Risk Management in Equity

The equity marketsare traditionally volatile with a high-risk, high-returns profile. As such investors in the equity market have to plan and strategize to reduce their risks and increase their returns.

This typically requires a two-pronged approach.

  • Protect stock value
  • Enhance returns
  • One classic way to protect the value of your investmentsis to diversify. This includes having investments other than equityin your basket as also including various sectors and companies in your portfolio.

    First, do not put all your eggs in the same basket. However much of a risk taker you are, it is always advisable to hedge your investments by partially investing in options that protect your capital. Some examples would be real estate, unless the market is over-heated as it is now, gold and pure debt instruments.

    Such investments should form between 50 to 90 per cent of the portfolio depending on the age of the investor and the corpus at hand. A younger investor or one with a large corpus can have an increased exposure to the equity market compared to and older investor or one with less funds at their disposal for investment.

    Even the equity basket should be a judicious mix of mutual funds and direct equity from various sectors. Again, depending on your risk profile and ability to choose shares, the proportion of investment in mutual funds and shares should be decided.

    By choosing shares from companies across sectors one can effectively hedge one's risks. For instance, choose to invest some of your corpus in FMCG majors, some in auto industries and some in the infrastructure sector. All three sectors, apart from the IT industry, are bound to perform well in the long term.

    In each sector choose companies that are market leaders as well as those that have a healthy earnings per share (EPS) for that sector.

    Companies in which the promoter has a substantial stake and those that have a high book value compared to the share price are unlikely to face capital erosion in the long term. His will ensure that the investor's capital is not lost, while generating high returns.

    Any company that is ripe for a takeover will give high returns even in the short term. A shrewd investor is one that looks for niche companies that will complement the strengths of an established market participant in the field. Such niche companies are bound to be picked up by the majors sooner or later. This is especially true of the IT sector.

    Yet another way to judge if a share is of good value is to check its dividend paying history. A company with a good track record here is bound to have a healthy P/E. The price to earnings ratio or the P/E of a scrip is another indicator of long-term value.

    To sum up, any investor in the equity markets should first ensure that their capital will not be lost. Diversification of the portfolio is a good way to make sure of this. The second step is to ensure that the stock is not valued at its full potential. This will lead to a rise in the price of the stock after the purchase of the share and ensure good returns to the investor.