Understanding Risk Models - Ways to Mitigate Risk

By Shilpi Ganguly

Stock markets never offer any guarantee, but an understanding of risk models associated with bonds and stocks and a little discipline while investing can help you mitigate unnecessary risk. While trying to figure out how to invest stock, keep in mind the risk factor and which of these risks can be eliminated or reduced.
There is always a relationship between risk and returns. Consider the following factors while weighing the risk in bonds and stocks:
1) Since returns are not predictable investors base their decisions on return expectations. These expectations should engage with reality.
2) Uncertainty entails risk. The greater the uncertainty surrounding an investment, greater the risk.
3) It is also possible the actual return won't meet the expectations of the investor. There can be many reasons for this: business risk or corporate risk, market risk, inflation risk, liquidity risk etc.
4) High potential returns also carry higher rate of risk and vice versa. Any claim of high return with low risk is seriously questionable.
5) The period of investment matters a lot. Do not invest in stocks or other volatile investments if the period of investment is less than five years.
Following these points will certainly be helpful. For example, during the last year share prices of real estate companies shot up sky high for a brief period and gave the impression of extremely high returns. Many people rushed to invest in these stocks at that point thinking that their returns would show a quantum jump, not realizing that their expectations were not grounded in reality. When the share prices crashed again many of them lost a lot of money.
Another example of risk associated with high potential returns is equity stocks. Equity stocks of companies such as Reliance, Tata, and Birla generally offer returns up to 25-30% but the risk associated is high as your capital can go down significantly. In comparison to that, bonds such as RBI bonds are more stable but offer between 5-10% return. So it would depend upon your risk appetite which scheme you would like to go for.
Another important but common way to tone down risk is to diversify your portfolio. Investments can be made in various categories of assets, such as money market funds, stocks, bonds and precious metals. Spreading your funds across different asset classes reduces overall risk. You can also diversify across industries so that your returns are not solely dependent upon one. These risk-reduction strategies can help you secure your future to a large extent.
Shilpi Ganguly is a blogger who frequently writes on various topics. Find more of her maximizing wealth in the stock market.
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