We began by understanding the necessity to invest for growth, the necessity to beat inflation and retire wealthy. Our adventure began the moment we discovered that equities are lucrative. Not exactly! No adventure can be successfully undertaken before understanding the basics. We figured out that the most important criteria to qualify for the journey is to be debt-free or, in simpler words, how much surplus we have after paying off all our obligations. We also understood a very important concept. Building of equity investments depends on two criteria: 1. Everybody can?t take the same level of excitement (Risk Profile) Then came the party pooper?Risk. The outside chance of losing instead of gaining. In our attempt to understand risk, we classified risk into ?Controllable Risks? (also called ?Company Risk? or ?Diversifiable Risk?) and ?Beyond Control Risks? (also called ?Market Risk? or ?Undiversifiable Risk?). Wake up! We know that ?risk? will always exist. Let us learn to tame it.We use a clich?o reinforce an age-old truth: ?Don?t put all your eggs in one basket!? Spread it around so that if one basket were to drop, only a few of your eggs break! Equally important is to decide: ?In which basket do I put my eggs in?? We will take this up in our next leg of preparation. Remember, we hope to make soldiers out of you! Let us understand our monster better?Equity Risk. Try answering this question below. For the uninitiated, ?Long? stands for a bought position in stock while ?Short? stands for a sold position in a stock that is not owned. Which of these options do you think is very risky? Which one is the least risky? Let us look at all these four choices? Choice #2 - Long TISCO & Long SAIL. Tricky hey! Two biggest players in steel. As far as company specific risks go, TISCO is a better bet then SAIL. So I am better off. Steel sector downtrend affects both of them. However, since TISCO is a more efficient producer, he will do better than SAIL. So I am better off. However, as far as market risks go, both of them get affected anyway. So I am indifferent. Adding it all up, Choice #2 is definitely better than Choice #1. We have learnt our first key learning. In choice #2 I had two stocks. I diversified. Voila! The risk reduced! So, diversification helps reduce risks! Choice #3- Long SAIL & Long HLL. SAIL is a steel company whereas HLL manufactures soaps, detergents?products that human beings will always use come rain or shine! These two companies are in different sectors. If the economy or steel sector does badly, I lose out on only one half of my investment! HLL is a well managed company, so I am better off. Hey, I am much better off than my earlier choice. I have split my risks between two unrelated companies and sectors. What about market risk? SAIL has a lot of sympathy with market movement whereas HLL is very stable (People can?t stop taking a bath just because the Sensex has been down for six months! Whereas people will stop buying cars and car companies will stop manufacturing and hence, steel companies will not be able to sell their steel!!) Choice #3 is excellent! We have learnt our next key learning: Equity risk is not additive! SAIL will have a certain risk on its own while HLL will have another one. But if we have the two of them together, then the risk of this basket will not be risk of SAIL plus risk of HLL. Remember, if SAIL is going down, HLL will not be as money flows to the safe stocks. Similarly, when the going is good, SAIL will outperform HLL. Choice #4 How all of us would give our right hand to own it! All these four stocks are leaders in their sectors. The sectors almost cover the entire spectrum of the market. At least two of them will be doing well. Any guesses on where it stands on our risk spectrum? Obviously, it is our first choice as it is the least risky. Another lesson: More widespread the selection of stocks, the better diversified and less risky a portfolio becomes. As the number of stocks increase, risk reduces. All these instances of diversification were able to bring the ?diversifiable risk? under leash. However, there is another kind of diversification that can take care of the more crazy ?market risk?! A combination of long and short positions!! Long HLL and Short SAIL. What have I achieved? These kind of combinations of long and short positions are used to mitigate market risks. Even the uncontrollable animal can be tamed! Market men call this ?Hedging?. ?Futures & Options?, which we will discuss later, facilitate this better. Now we know how diversification helps reduce risks. Did anyone bother to ask: ?What about returns?? Well, the clever ones among you would have figured out that by limiting our downside, we have parted with a bit of the upside! So there is a trade-off. Achieving the right balance between risks and returns is the key. Laws of nature apply here too??Strike the right balance?. We will try to take up optimisation or maximising returns for a unit of risk very soon.
2. Individual cash requirement (Liquidity Requirement)
1. Long SAIL
2. Long SAIL & Long TISCO
3. Long SAIL & Long HLL
4. Long HLL, Long TISCO, Long ACC & Long Infosys
Choice #1-Long SAIL (our PSU steel company). I am exposed to company-specific risks (inefficient manufacturer, bureaucracy...). I am exposed to the steel cycle too (what if steel prices drop 5%?). To top it all I am exposed to the market risk (Vajpayee government?s fall takes the Sensex down 200 points. Want to know my SAIL price? It has hit the lower circuit!) Gosh! I am exposed to every conceivable risk.
Let us look at company risks. Since, I hold HLL I own the company risk whereas if SAIL goes bust because of a company-specific risk, I gain because I have already sold it. With respect to market risks, if the market goes down, SAIL goes down more than HLL so I don?t lose money at all! In short, by using this combination I have only taken company-specific risk. A risk that I understand and can control.
Ideas that worked out for me which I would like to share with others
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