To play is always Risky

While reading through the past learning pieces, did you ever say to yourself: ?Such huge returns? Too good to be true. There must be a catch somewhere.? Or did Nagesh?s father?s apprehensions regarding market volatility and concerns over companies faring badly unsettle you? Did our reference to equity risk, ?no free lunch? and risk profile leave questions unanswered? We sure hope it did, because understanding risks associated with equities and learning how to manage them is the key to achieving higher returns from equities. Remember, the most important features of a fast car are the brakes and the steering wheel?not the accelerator! We begin our own humble attempt to understand this monster that can gobble up all our hard-earned returns!

Why have equity prices fallen in the past?

* Whenever governments have fallen; political instability (Top-of-the-mind recall)
* Inflation hitting double digits; rupee falling; interest rate hikes (the knowledgeable will tell you these are broad economic parameters that affect all businesses)
* A lot of people will tell you that wars have spooked the market?Gulf War, Kargil crisis, etc (country and lives are at stake.).
* Scams!! (Human greed knows no bounds).
* Bad management interested in making a quick buck themselves
* Company?s products bombed (Bad luck, bad strategy or bad marketing?).
* Lakshmi Machine Works suffers as textile mills are not doing well (a case of a specific sector going bad that wipes out even the best of companies).
* A chemical company?s plant caught fire destroying it completely (God save us!)
* A brilliant product but the company?s borrowings strangled the product before it saw the light of the day (Debt leads to death!)

So many of them, you ask? Let us see if we can classify them into broad categories. If you look at these reasons in detail, you realise that there are some factors that are within the company?s control or specific to the company?s business (bad management, products bombing, sector downslide, fire, borrowings?). The rest of the factors (politics, macroeconomic issues and wars) affect the market in general.

OK, we seem to have got two watertight classifications for equity risk. One affects specific companies and sectors. Textbooks have various names for it??diversifiable risk?, ?unsystemic risk?, ?business risk?, ?company risk? and so on. The other set of risk affects the entire market??undiversifiable risk?, systemic risk?, ?market risk?.....

The amazing power of classification! Suddenly, our big list of risks looks manageable. We just need to understand which basket they belong to! To get the classification right, let us delve a little deeper into the two groups. We will take up the ways and means of tackling these risks in our next session (lest we suffer from overload).

Company risk: a closer look
Though company risk is specific to the company, some risk factors that affect the business are within the control of the company. Corporate India is replete with instances of how a company could have controlled its future better.

Real Value?s (the ?Ceasefire? company) ill-conceived foray into ?vacuumisers? is an example of strategy going haywire. There are hazar Indian promoters who have siphoned money from their listed companies?examples of bad management. Core Healthcare (earlier Core Parenterals) is another classic example of a company that had the right product but, in its urge to build mega plants, it borrowed beyond its means before creating a market?the rest is history (the company got into a debt trap, and the product became a commodity).

All these risks can be avoided if proper homework is done to understand businesses and make a future looking call on their businesses. Only stock-picking skills can see you through this maze of risks. Now you know why good research analysts are so sought after!

The other sets of risks that are business specific are beyond the control of the company. What can Madras Cements do if the cement market suddenly slumps as there is too much new capacity with no matching demand! What can TNPL do if demand for newsprint falls as more and more people take to reading newspapers on the Internet! (Not now! But it can happen 10 years down the line) What can Tisco do if Posco dumps a million tons of steel in the country (not literally!)!

Of course there is something that these companies can do to rework their strategies, but it is time consuming. And you know our stock markets! The prices will get hammered with the first waft of bad news. In any case, if one were to diversify one?s holdings across various sectors and companies, the risks can get minimised to a certain extent. Risk diversification is another useful concept to understand, which we will take up next time.

Market risk
Company risk is still easy to contend with, but what do we do about market risks? Out of the number of factors affecting markets, our experience tells us that market declines under many of these factors are temporary and provide excellent buying opportunities for the patient investor who thinks and buys good companies (We love this kind of an investor or company)

Market risk is a different animal altogether. Diversification does not help as all stocks get affected by these factors. But fret not, the native ingenuity of mankind has found solutions to this problem too, in the form of ?Futures? & ?Options?.

We will be writing soon about the mechanisms behind such high-sounding terms and how you can use them (whenever they start here!)