The importance of risk management has never been greater than it is now. Considering the increasing pace of globalisation, the threats that contemporary firms face have become more complicated. While new threats emerge on a regular basis, investment risks are largely bucketed into the following three categories: market, business, and corporate governance risks.
The risk of losing money on your investments due to market risks is unavoidable. Market risks affect all investments, no matter how large or small they are. Even if the businesses you have invested in are doing well, your investments may be valued at a lower price by the market. Or, if you decide at any point to liquidate some or all of your holdings, buyers may be unavailable. The golden rule to remember is to safeguard your principal. While such risks cannot be completely predicted or avoided, a portfolio can be protected by being vigilant, cautious, and aware of the market changes in order to limit exposure to risk.
One tactic to safeguard yourself from market risks is through appropriate capital allocation. Diversification is beneficial in a variety of ways and, therefore, investment in multiple asset classes reduces unsystematic (investing in a single company) risks, since the loss is restricted.
Which assets you decide to add to your portfolio is also important here. When you combine a number of non-correlating assets, you will get a more balanced return, because you will always have an alternative to fall back on if one of your chosen investments is adversely impacted by market fluctuations. This reduces the volatility of your portfolio. However, it is equally important to avoid the other extreme of too much variety in your investments.
Owning and operating a business always comes with its own set of risks. Consequently, your investment is subject to the risk of the business underperforming. For instance, when you acquire a stock, you are buying a part of the company’s ownership. Alternatively, when you purchase a bond, you are lending money to a corporation. However, these investments require the company to remain in operation in order to generate returns.
Common investors are the last in line to receive proceeds if a firm goes bankrupt and its assets are liquidated. Typically, in such instances, bondholders receive payment first, followed by preferred stockholders. If you own common stock, you will receive whatever is left over, if anything. If you are buying an annuity, make sure to evaluate the financial strength of the organisation that is offering it. You want to be assured that the company is financially stable and likely to continue operating successfully in the long term. To identify such risks, a thorough study of a company’s specific business activity is required. In this case too, one should use capital diversification in the same way that one handles market risks.
Corporate Governance Risks
Corporate governance is important, because it sets forth a system of rules and policies which govern the operation of a company, and how the interests of all of its stakeholders are aligned. Such oversight enables ethical business practices, which in turn, lead to financial viability.
As an investor, you want to make sure that the firm you are considering investing in has robust corporate governance in order to protect yourself from any losses.
If you invest in a company that has low corporate governance standards, you risk exposing yourself to the impact of potentially fraudulent activities, such as window dressing of books and syphoning off of business funds. One should also exercise a high degree of diligence, when it comes to examining the functioning of a company’s management. The first step towards checking this is reading the auditor’s report of the company, which can be found in the financial statements filed with the stock exchange.
Always keep in mind that we don’t manage risks in order to avoid them completely, but in order to understand which ones will help us achieve our investment goals and pay off sufficiently to justify taking those risks. In the end, all investments involve some level of risk. However, by better understanding the nature of the risk and using measures to limit exposure, you place yourself in a better position to achieve your financial goals.
Besides keeping the above points in mind, it is also essential to maintain appropriate liquidity, seek financial counsel before investing, and cover an enterprise-wide view using effective enterprise risk management strategy. Making an investment does not mean that your work is done; rather, it has just begun. That’s because, understanding the market, keeping an eye on fluctuations and trends that could affect your portfolio, evaluating your investments, and reworking your asset allocation when necessary, are all critical to reducing risks in your portfolio.
Hersh Shah is CEO, Institute of Risk Management, India Affiliate, and Mohit Mehra is Head of IPO, Zerodha
(Disclaimer: Views expressed are the author’s own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.)