Stock market risky hai.
Whether you are a novice or an experienced investor, it is highly likely that you have heard this statement at some point.
Here is my latest encounter with this statement.
It was a bright and sunny afternoon, and I was sitting with my father in the garden. My father had recently retired from his long career as a civil engineer, and I wanted to encourage him to stay active and pursue something interesting and challenging post retirement.
No prizes to guess what I was going to suggest - investing in stock market.
Just so that you are aware, he is an out and out FD and PF guy. And of course, a firm believer of money is great to have but bad to enjoy. I am damn sure a lot of people can relate to this ;-).
"Dad, I have been thinking about what you could do in your retirement to keep your mind and body active," I said. "Have you ever considered investing in the stock market?"
My father's face contorted with apprehension. "Investing in the stock market? But, stock market is risky. I don't want to put my hard-earned money at risk that too at this age."
Sorry, but don't know why I suddenly heard a voice speak in my mind:
पूत सपूत तो का धन संचय, पूत कपूत तो का धन संचय
Anyways, you might be thinking that it's not surprising for a hardcore fixed deposits person to be hesitant to invest in the stock market.
I too am ok with that. However, let me tell you what I am not ok with.
Given the fact that he has never ever bought a stock and he has never ever invested in mutual fund, let alone lose any money, how did he come to know that Stock Market is Risky?
To figure out, I probed further.
"Dad, I understand your concerns, but can you tell me how you reached the conclusion that stock market is risky?"
His answer was surprising. Or may be not.
He said, I more often than not hear "There was bloodbath in stock market today" on the news channels. And then I see a lot of people with hands on their head on the screen. What else can I infer?
Fair enough, I thought but continued to persuade him.
"Dad, I understand where you are coming from, but investing in the stock market, if done right, can be a rewarding experience. Plus, with your retirement, you have more time to research and analyze the market. Not many people have that luxury."
I further explained how investing in the stock market would provide him an opportunity to learn new skills, stay active, and potentially earn a healthy return on his investment. I reminded him of the importance of being open to new experiences and taking calculated risks to keep the mind and body active.
Over the next few weeks, I helped him research various investment options and understand the risks involved. We discussed investment strategies, analyzed market trends, and explored various investment vehicles.
Gradually, Dad began to see the benefits of investing in the stock market. He started to invest small amounts of money and learned to make informed decisions. As he became more confident in his abilities, he began to take more risks and found that investing in the stock market was not as intimidating as he had thought.
This is not what actually happened.
This is what actually happened.
I failed miserably at convincing him and the discussion ended as it always ends between a father and a son. Do I need to say more ;-)?
As they say, happy ending is only for Bollywood.
After few days of this gigantic failure (actually they are countless with my dad), I received a call from a gentlemen. He was planning to begin in the stock market. So I casually inquired - How much you know about the stock market?
He started by saying - waise to ye bahut risky hai but....
And I was like, what the hell is going on. How come every beginner has this ब्रह्म ज्ञान.
So here I am writing this article to make every beginner aware that the following equation
Stock market = Risk
is a totally and absolutely wrong equation to start with. You need more context.
It occurs to me that beginners to the stock market may be confused about the concept of risk. They somehow feel that whosoever enters the stock market loses his capital. Sadly, this is not true.
Let me tell you an interesting thing about the concept of risk in general.
If you know their is risk, then at the exact same moment you also know that it can be avoided.
Risk does not have a stand alone existence.
For example, there is a risk of drowning but you can avoid it by using floats or not going into deep waters in the pool. Here are few other every day examples.
|Risk||Steps to avoid the risk|
|Risk of getting into a car accident||Follow traffic rules and regulations. Avoid driving under the influence of drugs or alcohol.|
|Risk of identity theft||Use strong passwords and enable two-factor authentication. Avoid sharing personal information on public platforms.|
|Risk of food poisoning||Cook food thoroughly and store at appropriate temperatures. Avoid eating raw or under cooked meats.|
|Risk of fire||Install smoke detectors and fire extinguishers in your home. Avoid leaving cooking or heating appliances unattended.|
Hope now you understand why Risk is a two faced coin with risk printed on one side and how to avoid it printed on the other. So in this backdrop, let me rewrite the first line of this article. I hope you remember the first line - Stock market risky hai.
Stock market is risky, but the risk is avoidable.
What I am going to do next is to pick the first part of the above statement i.e. Stock market is risky and add more context to it. The idea is to tell you that Risk is not black or white. There is a lot of grey in between. Once the true nature of risk in stock investing is revealed, I will focus on the second part of the statement and tell you how to mitigate the risk.
Ultimately, I want to convince you that risk simply does not exist if you let your common sense drive you in stock market. That's the challenge I have set for myself. So let's see, how I fare in this challenge to convince you.
|Part 1: Stock market is risky|
What is risk?
In simple terms, "risk" in the stock market refers to the possibility that your investment may lose value or fail to meet your expectations.
Risk = Expectation - Actual Outcome
We will come back to this equation later. Let's first try to understand risk in pure layman terms. As a stock market investor, you get exposed to any of the following three risk categories:
1. Risk of complete wipe out:
You purchased the stock of a company and it went bankrupt. You lost the principle you invested i.e. 100% loss. Now think and answer this question. Can you lose more than 100% in stocks? If you think the answer is no, then 100% is the lower bound of the risk in stock market.
But what if the answer is yes. Yes it can happen while using leverage, however that's a story for later.
For the time being, let's carry on with the belief that -100% is the lower bound for the risk you carry with stocks.
2. Risk of under performing the FD returns:
The second category of risk is getting return which is less than what you can earn elsewhere.
By elsewhere I mean 3 things. One, you remain in cash, two, you keep your capital in saving banks account (4% return) and three, you did an FD (6% return).
So if you were not able to preserve your capital, but also did not lose all of it, then you fall into this category. Generally speaking, this is what happens with vast majority of stock market participants.
3. Risk of under performing the market:
The third category of risk is getting a return above 6%, but less than long term average stock market return which is something round 12%.
Can you think of any other category?
Now, having understood the risk categorization, let me tell you what a beginner means when he says stock market is risky.
More often than not, the beginner derives this conclusion straight out of scenario of complete wipe out.
However, he misses on fact that risk of total wipe out is completely avoidable without possessing any special skill.
I don't blame him for missing this part of equation though. It is quite understandable as he gets to hear horrible stories about this scenario more often than not. Remember, where from my Dad got his risky notion about stock market? The headline: "There was bloodbath in stock market today".
Now re read the point 3 above. What it actually means is:
If you are earning anything above 12% in longer time frame then believe me, you are doing great and the risk is only in your mind.
Does it sound like a dampener? Only 12% return, then why the hell should I invest in stocks? If this is what you are thinking, then let me make you rethink. Answer the following question:
What investment options you know that provide a genuine return of 12% or above on long term basis?
If your list has less than 2 names, then me peddling stock market investment to you is automatically justified. No?
Besides, you are also missing the point that the base case scenario of 12% returns from stocks is twice that of 6% (your FD returns). Put another way, what it means is, your money has the potential to double in 6 years if invested in stocks as compared to 12 years if invested in FD. How? I simply used The Rule of 72 for this approximation.
But why 12% which is double of what you currently earn on your investment sounded like a dampener in the first place? Time to get back to the risk equation which I introduced but did not elaborate on earlier. This equation will answer the why:
Risk = Expectation - Actual Outcome
Expectation is the keyword here. Let's try to decode the above equation by substituting some real life data. We will start with what you are already familiar with and then gradually shift to example pertaining to stock market.
Let's say you have some capital and you put it in savings bank account. You know that bank will offer you 4% return on the amount and you are ok with it.
|Your expectation of return||Actual return by bank||Risk = Expectation - Actual Outcome|
|4%||4%||4% - 4% = 0|
What you expect is what you get at end, so virtually no risk for you in this investment as per the risk equation.
Let's say you have some capital and you put it in fixed deposits account. You know that bank will offer you 6% return on the amount and you are ok with it.
|Your expectation of return||Actual return by bank||Risk = Expectation - Actual Outcome|
|6%||6%||6% - 6% = 0|
Here too, what you expected is what you are getting, so virtually no risk for you in this investment too.
The key thing to note here is the return which the bank offers (actual return) is well know and constant. So no one has any fancy expectations about the returns.
Let's enter the stock market now. Imagine there are 3 friends named Dhodha, Mangroo and Ramkhelawan. They are pure FD guys and have never earned more than 6% return in their life. One fine day they decided to buy the shares of a company A. They all got to buy the stock @ 100. One year later, they all sold the stock at @ 106 (actual return of 6%). Needless to say, they all had different expectations from this investment at the beginning as depicted in column 2 below.
|Name||Return expectation||Actual return from stock||Risk = Expectation - Actual Outcome|
|Dhodha||40%||6%||30% - 6% = 24%|
|Mangroo||15%||6%||15% - 6% = 9%|
|Ramkhelawan||6%||6%||6% - 6% = 0%|
If you look carefully, you will notice that they all performed equally well or worse. However who you think would be most disappointed of the lot?
Expectation could be deadly at times, however am not sure about over expectation.
You must be wondering where from they got the motivation to set such varied expectations?
There are three ways people set return expectations:
1. Based on Historical returns:
Based on past performance of the market, people may expect similar returns in the future.
2. Based on Expert opinions:
People may rely on the opinions and recommendations of financial experts or analysts to set their return expectations for the market.
There is a third way too which Dhodha seems to be a firm believer of which is:
3. Mann me aaya, expect kar liya:
The difference between a calculated risk taker and a lunatic lies in the approach they take towards investing and the degree of risk they are willing to accept.
A calculated risk taker is someone who takes well-thought of risks based on analysis and research, whereas a lunatic takes reckless risks without due consideration or expertise.
The difference between the two lies in the level of risk analysis, research, and informed decision making.
It's important to strike a balance between taking calculated risks and avoiding reckless behavior, which can result in severe financial losses.
Can you help me identify the lunatic among the three?
Time to get back to the original question which we were trying to answer i.e. why 12% which is double of what you earn from your FD sounds like a dampener?
Does it still sound like a dampener after having understood, how people set expectations? It should not, else I accept my defeat in not being able to convince you.
Believe me, almost all of the beginners use the 3rd way of setting expectations till they have spent approximately 5 years in the market.
And then they come to know that market on an average returns 12% on long term basis.
So expecting anything above 16% blurs the fine line between being a risk taker and a lunatic.
Risk taker is the one who is willing to accept some level of risk in pursuit of their investment goals, but they do so in a calculated and informed manner. Calculated and informed manner means using option 1 and 2 above to set the right expectations.
A lunatic, on the other hand, takes excessive risks without proper consideration and may be blinded by unrealistic expectations of returns. Taking excessive risk in the stock market refers to investing in highly speculative or unproven ventures without proper analysis or risk management. For example, investing a large portion of your portfolio in a single stock without diversification or investing in volatile penny stocks without proper due diligence. It also includes using leverage (FnO, Margin Trading) beyond one's capacity and blindly following hot tips or rumors without verifying their authenticity.
So what do you mean? No one earns returns above 20% in the stock market? Are you nuts?
If this is what you are thinking then let me assure you, I am not nuts.
And there are people who earn above 20% on consistent basis for sure.
Having said that, if you are reading this and you have spent < 5 years in the market, and you are feeling a bit enraged at the moment, and your portfolio has not beaten FD returns since the beginning, then you still have a lot to learn to earn more than 20% on a consistent basis.
I want to emphasize that I'm not saying this to discourage you, but rather to encourage you to make necessary adjustments. And those adjustments will be easier to identify and implement when you come to terms with the true nature of risk.
Remember, the other face of the coin I talked about earlier.
Having understand the nature of risk, it's right time to explore ways to avoid and minimize those risks and safeguard your investments. As it's going to be a lengthy discussion, I have covered it in next part of the 101 series. I will meet you there.
|Part 2: But the risk is avoidable|