Investors have a love-hate relationship with risk. We feel warm and fuzzy about it when it works in our favour. We loathe it when it works against us. Ultimately, we are married to risk, for better or worse, until death do we part.
There are a lot of risks that vary in terms of their level of certainty and the magnitude of their impact.
Death is easy enough to hedge with life insurance.
Taxes, while equally certain, can vary in magnitude. The future of tax policy and its implications for investors is a known unknown. You may invest in the Public Provident Fund, or PPF, based on the fact that it is exempt from taxes completely (EEE). But the future is unknown.
The "person in the mirror" behavioural risk--the odds that we will do something silly and shortsighted with a significant portion of our investments--is perhaps the biggest risk we face. It is also one of the most difficult to manage.
Here we look at two risks and how to manage them.
Systematic Risk
Systematic risk is like gravity. There’s no avoiding it. It is a fundamental force that shapes everything around us. Also known as market risk or undiversifiable risk, it is typically the biggest risk that investors face.
Systematic risk is driven by two key economic variables: growth and inflation. The long-term returns of virtually all assets (we'll set aside cryptocurrencies and Beanie Babies for now) are a factor of these two inputs. If the economy grows and growth translates to rising cash flows for companies, equity investors will be rewarded for assuming risk. If inflation runs rampant, bondholders will be punished.
The primary means by which we can govern our exposure to systematic risk is through asset allocation. Asset allocation is like the main tuning knob on a stereo receiver. A few turns of the wrist will take you from 93.1 WXRT to 107.9 WLEY. Changing your mix of stocks, bonds, and cash is the easiest way to move the dial on the level of systematic risk that you assume. Want to take less risk? Turn the dial toward bonds and cash. Want more? Spin it toward stocks.
The right balance is inherently personal. In theory, it will depend on your willingness and ability to take risk. In practice, measuring these is part art and part science. Your judgment of your willingness and ability to assume risk will likely fluctuate depending on things like your mood, recent market performance, and changes in your personal circumstances. As such, it's important to regularly reassess your risk appetite and your risk budget.
Your asset allocation may not be (or might not feel) as appropriate today as it was when you last reviewed it on an empty stomach in August 2015, when the Sensex ended over 1,600 points down--just before you retired.
You can also manage the level of systematic risk you take within a given asset class. Investment selection is akin to the fine-tuning knob on a stereo receiver, which is the most precise means of turning the dial from 101.1 WKQX to 101.9 WTMX.
Idiosyncratic Risk
Systematic risk is general. Idiosyncratic risk is specific to a firm and is not dependent on how the market moves. Growth and inflation drive systematic risk. Idiosyncratic risk springs forth from an infinite number of things. Will Tesla be able to meet its latest Model 3 delivery targets? Will Lyft ever turn a profit? The answers to these questions depend on the answers to countless sub-questions, virtually all of which are impossible to answer precisely.
This mix of Rumsfeldian known knowns, known unknowns, and unknown unknowns gives rise to idiosyncratic risk.
These risks are specific to the firms facing them and the markets in which they operate. The potential gains for assuming this narrower form of risk are greater than market risk, but so are the prospective losses.
The best means of managing idiosyncratic risk is to simply diversify. Moving from a one-stock portfolio to a 20- or 30-stock portfolio diversifies away more than 90% of the idiosyncratic risk of a basket of individual equities, leaving mostly market risk. Owning a diversified portfolio of funds leaves investors facing (maybe) a shred of residual firm- or issuer-specific risk.
This article initially appeared on Morningstar.com and has been edited for an Indian audience.
