How to Avoid Stock Market Risk

Welcome back! In our last discussion, "Understanding Stock Market Risks," we explored the crucial concept of risk in the stock market. Now, we'll be diving into the next step, which is "How to Avoid the Risk".

Before we move on, I strongly recommend that you read the previous article to gain a better understanding of the foundation we'll be building upon. That article provides essential context and background information which will help you get the most out of this one, where we'll be looking at some practical strategies that can help you minimize risks and protect your investments. So let's get started!

Here are some more tidbits additional to what we discussed in part 1 that will help in revealing the true nature of risk:

• Risk is relative, meaning it can vary depending on the context and perspective.

• Risk is subjective, as different people may have different perceptions of risk based on their experiences, attitudes, and values.

• Risk is not constant and can change over time due to various factors such as market conditions, regulatory changes, and technological advancements.

If you've been following along, this is what we learned in part 1:

1. We learned about the true nature of risk

2. We also learned about the basic method for quantifying risk, which is through the risk equation.

3. And we also know that risk is not found alone. The antidote almost always accompanies it.

The Antidote - How to avoid risk in stock market?

As I said earlier, risks are almost always avoidable.

And can surely be mitigated if not completely avoidable.

In summary, the key difference between "risk is avoidable" and "risk can be mitigated" is that the former suggests eliminating the risk altogether, while the latter suggests taking actions to minimize the impact of the risk.

I will provide examples of how both approaches can be used to manage risk effectively.

And the most potent weapon you will need to succeed is pure common sense. By the way, is common sense an abundant or scarce resource? I am confused :-|.

But before I tell you how to avoid the risk involved in stock market, allow me to tell you where this risk actually comes from.

Hear this:

Origin of almost all kind of risk lies in our inability to see the future.

Think about it for a moment. You will surely appreciate how simple yet profound this statement is.

Now imagine yourself being one of the following:

1. The smart guy - you are smart enough to buy all the stocks which goes up next day till they are multi multi baggers.

2. The not so smart guy - you are not so smart and so you keep on picking some losers and some winners along the journey.

3. The dumb guy - you are dumb enough to buy all the stocks which goes down next day till they reach 0.

Which one you identify with the most?

If you think carefully, you will come to a conclusion that no one, and literally no one, can be type 1 or type 3 on a continuous basis. Everyone is type 2, which simply put is nothing but a natural manifestation of the fact that no one can see the future.

Having agreed that you are type 2, don't you think avoiding or minimizing risk in stock market is basically an optimization challenge, wherein you need to take steps which enables you to pick more winners than losers and stay with them. And here is the best part:

If your performance on this optimization task is just average, your potential return will be a CAGR of 12%. 

And if your return expectations are not too lofty (not above 16%), then as per the risk equation, you will earn 12% without bearing substantial risk (risk of 4% variation on the lower side).

Trust me, you won't hate being in this situation where in you expected 16% but got 12% return once you learn that most retail investors are not even able to generate FD returns on their stock portfolio.

This brings us to the next obvious question: Why most investors are not able to beat even the FD returns?

And the obvious answer is, they try really hard to be type 1 (which is virtually impossible), and in doing so they more often than not end up being closer to type 3. 

Ever heard of this:

No human respects what he already has

All investors are humans. All humans don't respect what they already have. All investors are type 2. But as they don't respect what they have, they want to be type 1 regardless of the fact that it's a futile exercise.

But greed blinds them of this fact.

So they resort to shortcuts like acting on get rich tomorrow stock tips, buying over hyped stocks, using leverage and committing virtually all other greed driven cardinal sins in the pursuit to be type 1. Then one fine day:

Bear market comes and पाप का घड़ा फुट जाता है |

But greed is such a powerful vice, nothing changes. This cycle keeps on repeating. 

After writing the above two sentences, I am seriously rethinking why I took up the challenge to convince you in the first place. It is a losing battle ;-). It's Greed Vs Goliath and greed will surely win hands down.

Anyways, it's too late to quit now. So I will give my best before being crushed.

But, let me remind you before I forget. Whatever you are going to read from here onward will sounds simple, however, will not at all be easy to implement in real life and you already know who will be responsible for your failure - Mr Greed.

Having answered why most investors fail to beat FD returns, let's get back to solving the optimization problem the right way. 

The end objective is to pick more winners than losers.

And here is the thing. Just by taking steps to avoid and minimize risk, you will automatically start picking more winners. Avoiding risk and picking winners are intertwined.

Let me explain how and for that i will have to once again remind you of our inability to see the future.

Here is a slightly modified version of what I said earlier:

Although it's impossible to see the future, it's some what possible to see very far in the future at times.

What do you mean by this? Isn't it contradictory? If this is what you are thinking then hear me out.

I don't know if I will die tomorrow or next month or next year, however i am damn sure I will not be around to edit this line in 2100.

What I am doing here is trying to predict some outcomes in the distant future using the lens of past. Meaning I am relying on historical data (life expectancy of 70 to 80 years) to guesstimate the future with immense accuracy.

Hope you got where I am coming from. Time to jump to an example from the stock market. 

Hear this, but don't be surprised. Also, here is a bet. No matter when you read the following line, it will almost always be true:

Yes we can fairly accurately predict that stock market will be substantially higher from where it is today in next 10, 20, 30 years.

How accurate? Just use a CAGR of 12% to predict the numbers.

Why 12%?

Because this is the Nifty growth rate for past many many years. Lens of past, you know.

Let me do the Nifty level prediction for 2043 (20 years).

Before you call me nuts again, look at the calculation below. Hopefully you will change your mind.

But actual Nifty Level on 27th Feb 2023 = 17,392

So actual CAGR of Nifty is above 15% in past 20 years and not 12%. 

Hopefully, now you agree that by suggesting Nifty Level of 167,768 in 2043, I am not being nuts, but being modest. Actually, the Nifty level might be double of that.

I propose you for a date in 2043 to crosscheck.

Double check the math and forgive yourself for calling me nuts ;-).

Just in case you need further validation, do the calculations for 10 and 30 years. 

I hope now you agree that we can predict outcomes too far in the future with substantial accuracy.

And if so, then won't it be prudent to craft our current actions so as to reap the rewards of those almost sure outcomes in the future. 

And I guarantee you, by crafting your current actions in accordance with the future outcomes, you will never have to think about stock market risk again. Delivering this key insight was the whole intention behind showing you the above calculation.

So here is the first thing you need to do to reap the rewards of future and of course avoid risk in stock market.

1. Think and act with long term mindset:

Stay with your investments. Remember:

Multibaggers are held, not found.

So you mean to say, buy some stocks and hold them till eternity come what may?

If this is what you are thinking then, the answer is yes. But let me clarify few things so that you are really clear on what you have to do and why it makes sense.

a. By eternity I mean at least 10 years.

Trust me on this - after 10 years you will be more than willing to sell your kidney, but not your portfolio. And I am saying this in a positive way.

b. Some stocks here mean a basket of 20 to 50 stocks from different sectors.

Technically, it is known as diversification. Any long term portfolio that has 20 to 50 stocks from different sectors automatically renders itself immune to risk of ruin. Plus some multibaggers will unknowingly slip into your portfolio.

Diversification:

1. Takes away the risk of complete wipe out

2. Increases chances of multibaggers to slip in portfolio

3. Allows to sit on your hands in high volatility periods

4. Enables you to harness the power of randomness

Which of the above a or b you think is more difficult to achieve?

Do you know what is the toughest thing to do in this world?

To Do Nothing.

Especially when you can do anything with immense ease. Buying or selling now a day is just matter of one click or swipe on your phone.

Don't believe me? Hear it from Mohnish Pabrai, an investor, entrepreneur, and author who has been successful in the stock market for many years. He is the founder of Pabrai Investment Funds, a hedge fund that has consistently outperformed the market since its inception. The interview has more than few nuggets on how to pick Stocks using common sense. Must watch, if I may say so.

A must read for the one who understands the value of standing on the shoulders of successful investors to gain insight into the market.

And in case you want to track his investments in Indian Stock Market, you can do it here on our Top Indian Investors Portfolio Page.

Anyways, let's get back to our discussion.

So sitting for 10 years without doing much is really going to be tough. How many achieve it? Not many.

Any beginner can execute b, however achieving a is what differentiates kids from adults and adults from legends.

As I said earlier, it will sound simple however won't be easy. 

Thinking long term and acting accordingly in itself is a necessary and sufficient condition to avoid all kinds of risk in stock investing.

Having said that, if you want to make your journey more enjoyable while simultaneously shortening the time frame to less than 10 years, here are two additional things you should do:

2. Do not use leverage

No trading on margin money. No borrowing to buy stocks. As they say: 

If you do not use leverage, 99% of the so called stock market risk simply does not exist for you.

How? Without leverage, you can hold onto your stocks even if the market experiences a downturn.

It will for sure.

If you are not using leverage, then you can wait for the market to recover, rather than being forced to sell your holding at a loss to cover the leveraged position. 

3. Start your investment journey in bear market

Most beginners start in the stock market at the fag end of a bull market. However, if you are reading this and have yet not started, then here is a humble request. Wait till the next bear market to begin your journey. 

But how to identify a bear market?

Just wait for the index (Nifty or Sensex) to fall by approximately 15 to 20% from it's previous top. Trust me, you will be able to do your purchasing at way cheaper price.

Yes managing risk in stock market investing could be as simple as this.

A three step process.

However, as I pointed out earlier, the toughest step of this simple framework is waiting and doing nothing.

I think I have said enough for now and feeling really great that we explored the true nature of risk and learned some strategies to mitigate it. Thanks for being with me till here.

रामायण  खतम हो  गयी  पर  सीता  माता  कौन  थी  ये  पता  न  चला  हो  तो:

Before I say final good bye, let me share a secret:

Arguments above are of absolute 0 value in case you are planning to use them to convince your father to invest in the stock market. Remember, I have been there, done that and got kicked in my .... (you already know where). 

Happy Investing!