How to reduce risk in investing?

Many people have misconceptions about the ways or paths of pursuit to investing. And especially in equity investing, many carry their own biases and past experiences. One common association with equity is loss though many fail to distinguish the difference between risk and loss. Risk is simply a situation involving exposure to danger.

The outcome of the decisions depends upon the event of risk materialising or not. So, mere presence of risk wouldn't cause a loss and that's where the opportunity lies. Investment thus is to do with the assessment of this risk, checking how far one could tolerate the risk and gaining from this arbitrage.

Traditionally, investors have been conditioned that all risk amounts to loss and so use these words interchangeably. Also, alternatively, people think about or relate investment to gains or possibility of gains. So, whenever there's a mention of risk, it's understood as direct loss and not the possibility of a loss. In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.

Investment risk could hence be defined as the probability or likelihood of occurrence of loses relative to the expected return on any particular investment. In other words, it's the chance that an outcome or investment's actual gains differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment. Thus, risk should be looked at the deviation of an investment's ideal outcome. When planning for an investment, we scout for the possible risks or events that could derail the final intended output. But, despite we making an exhaustive list of risks, there could be some event that could disturb the applecart. Ellory Dimson profoundly puts, risk means more things can happen than will happen. So, it's the unknown unknowns, the things we don't know we don't know – as put by Donald Rumsfield that would alter out planned expectations. Though, he mentioned that in the context of war, it very well could be used to describe the impact of risk in an investment.

Every outcome is a measure of probability. There's a chance that one make a good decision and still end up with a bad outcome. The former is called risk and the latter luck. They could be the sides of a same coin but we treat them differently. Risk is seen as something that happens to us while luck is treated as something we do to ourselves. This fallacy is best seen in the self-attribution bias. Conversely, we choose to attribute the cause of an outcome based on what makes us look best. This is why we own up to our skill when things move as per our plan and when they deviate from the plan, we call it bad luck.

Nassim Taleb in his book, 'fooled by randomness', says one can have luck on their side for a long time until the 'fat tail' become a reality ie, until disaster strikes. So, we hear/witness lots of overnight tragedies but no overnight miracles. Even as we come up with possible events that could hamper the outcome, things invariably happen, those that are beyond our imagination. Unfortunately, those are the ones that matter the most. Carl Richards says it best: "risk is what's left over when you think you've thought of everything else."

One should comprehend the fact that risk is always inherent and present, at all the times. We can't avoid it but we could certainly manage or mitigate it to our benefit. This is where one should be aware of their individual risk tolerance and not overstep it. This is what derives the risk to reward paybacks in an investment. In direct equity investments, this is defined by the stop-loss for a security. It acts as insurance to the investor and hence considered sacrosanct. Insurance is another great way to reduce the risk. By covering with insurance, the risk is transferred to another individual/entity that has the capacity to tolerate such a risk or an extent of loss. Hedging is another such exercise which is an example of insurance where the risk is dodged by a countervailing investment or strategy so that the initial investment outcome is ensured. Another good risk mitigation strategy is to create a portfolio of investments. This achieves diversification and thus possibly reduces the overall risk of the portfolio. To achieve better diversification, one could opt for instruments or investments within a portfolio which are least or less related to each other. This allows the investment to perform across most of the times irrespective of the market conditions. Of course, each risk mitigating strategies come at a cost. By moving out of an investment as it hit the stop-loss, the opportunity of participating in future gains is offset. Insurance and hedging come at a price and one has to pay a premium to ensure the desired outcome. Also, diversified portfolio mayn't outperform when the market is unidirectional. But, one has to find that sweet spot of risk to reward to benefit by playing around the risk.

(The author is a co-founder of Wealocty, a wealth management firm and could be reached at knk@wealocity.com)