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'Risk or volatility?' This is the first question that an investment advisor should be asking you. But the first thing you should be asking him is 'How much volatility should I expect in this investment instrument?' Because every investment is just a risk-return trade off.

When you endure saturday evening dinners with your in-laws in exchange for a sunday of television watching, you are doing a trade-off. Life is all about trade-offs and so is investing. Getting a return on your investment means accepting risk, at least to some extent. But what, exactly, is risk? And how much of it can you tolerate?

 

We will review the types of risk involved in investing, and show you how to develop your philosophy about investment risk. An institutional investor considers variation from the mean as the risk. A retail investor on the other hand considers reduction in principal as a risk. How many of us understand that in the short term equity is risky (actually volatile) and in the long term debt is risky (it is not appropriate vehicle to reach your goal)?

 

The other questions to ask are: 

• How much can I lose?
• Will I get it when I want it?
• In a retiree portfolio, will I outlive my portfolio?

Investors face many types of risk. First, there is the risk of losing money over the short term. This is also called volatility. Shares have returned 17%, on average, between 1979 and 2006. However, during one of those years, shares lost money in a calendar year. Bonds are not immune, either. Most recently, bonds finished 2002 and 2003 in the red.

 

And over shorter time periods, a few weeks or months, investments can be even more volatile. Investors focus almost exclusively on this type of risk. It's easy to do. Every day you hear about how the market is doing on the radio and television. And if that is not enough, the internet and sms have ensured that you can check your stock prices throughout the day.

Keep your goals in view
Don't let volatility get your goat, though. If you are going to chase your advisor because of short-term volatility, may be you should not have been in the market at all.

 

If you do, you will virtually ignore the second and perhaps even greater risk that comes with investing: the risk that you won't meet your goals. How can obsessing about volatility get in the way of your goals? It may cause you to invest too conservatively. It may cause you to pull out when the market has fallen 30%. It may cause you to get in when the market has risen 30%, a classic case of buying high and selling low. This has been the family pastime of some of my clients.

 

Volatility also may lead you to buy or sell an investment based on short-term performance rather than on how this purchase or sale will help you reach your goal. In short, volatility can prevent you from seeing the forest for the trees. Think hard about the goals that you have set for yourself. Reaching there at the correct time is more important than the speed of the car in the next five minutes.

 

Now when you are thinking about short-term volatility and your acceptance of it, consider some of the specific risks associated with investing. Think of volatility as the byproduct of risk - when risk happens, volatility ensues. But by diversifying your portfolio, you can reduce the impact of any one of these risk factors, and therefore limit your short-term volatility.

 

Market risk

When the market moves in the opposite direction of what you think it will, risk happens. Market risk comes with exposure to a particular asset class or sector, such as equities or a particular sector of the industry. It is the threat of the entire market losing money. That can happen if investors think that the stock market is selling well above its prospects, for example, or that banking shares as a group are going to face slower growth.

 

To limit market risk, diversify into various markets and sectors. By doing so, you are reducing your portfolio's dependence on a single market.

 

Company-specific risk

Operating risk and price risk are two factors contributing to short-term volatility of individual shares. Operating risk is the risk to the company as a business and includes anything that might adversely affect the company's profitability. Price risk, meanwhile, has more to do with the company's stock than with its business - how expensive is the stock compared with the company's earnings, cash flow, or sales? To limit company-specific risk, own a collection of shares rather than just a few.

 

Economic risk

Inflation. Interest rates. Economic growth. Bernanke. Deflation. China story. China demand. Changes in these factors, or even rumors of changes in these factors, can lead to short-term volatility. To limit economic risk, buy securities that do well in different economic scenarios. Bonds and high-yielding securities (such as utilities shares), for example, generally perform poorly when interest rates rise; balance those investments with high growth shares. If the rupee gets stronger, importers benefit, if the rupee gets weaker, exporters benefit. If oil prices go up, oil manufacturers benefit, if it goes down, auto manufacturers benefit. If interest rates go up lenders benefit, if it goes down, borrowers benefit.

 

Country risk

Whether you invest only in Indian shares or put some money outside the Indian market, you are exposing your portfolio to the risks of investing in that country. There's political risk, or the risk that the current leadership will change for the worse. Then there's the risk that the currency will lose its strength versus other currencies. To limit country risk, do one of two things. If you own both Indian and foreign securities, invest in a variety of markets, not just a few. For example, make sure some of your companies have expanded internationally. They will probably be more resilient than less-diverse companies when the economy slows. An auto ancillary like a Pricol of a Bharat Forge or an indirect supplier like a Carborundum Universal is likely to be less affected by a slow down in the auto market in India than a Telco or a Maruti.

 

The author, PV Subramanyam, is a financial domain trainer. He can be reached at pv.subramanyam@moneycontrol.com .