The other side of risk

Risk is often assumed to be “volatility” (measure of variation of price over a period of time), which is quite bizarre, ask any trader, for him / her it is bread and butter. 

Volatility in stock prices creates opportunity, your actions create risk.

So what is risk

One aspect of risk is loss of capital, so when we buy into something which has a high probability of faltering and going down we tend to take more risk ( think : buying IT stocks ’99, real estate and infra ’07 )

There is another aspect to risk which tends to get sidelined.

Picture this, there are ~5000 securities to choose from (India alone), As long term investors, we will typically hold ~20-25 ideas in the portfolio (beyond which diversification loses its significance).

We are betting on the fact that this small portfolio at any given point of time, comprising just 0.5% of the overall universe of stocks available will beat the market consistently over the long run (Only referring to long term, not the short term variations)

  While buying into an idea we are faced with two kinds of risks:

  1.     Loss of capital: Risk of downside from purchase price
  2.     Opportunity risk: Risk of under performance relative to better ideas

So let’s say, I bought Reliance Industries in the 1st week of January, 2009 at ~Rs.700, 1st week of January, 2015, price is ~Rs.930, so 6 year CAGR works out to be ~5%, my fixed deposit did better.

There is no loss of capital and I even got dividends, however it turned to be a poor investment decision, opportunity risk was very high (think: returns in Pharma, IT in the same periods)

Historical market returns have been ~16%, our portfolio has to beat this to justify the extra effort and risk.

We have to find ideas where the risk to capital and opportunity are low and consequently the probability of market beating returns higher.