Anyone who has watched the Sensex swing by hundreds of points within a single session knows how unsettling volatility can feel. Prices jump on unexpected news, portfolios change colour within minutes, and even confident investors begin to doubt their plans. Yet volatility is not an accident; it is an inherent feature of equity markets, and INDEXNSE: NIFTY_50 has experienced countless turbulent phases followed by recoveries. The real question is not how to avoid volatility but how to prepare for it. This article outlines practical, easy-to-follow risk management techniques that Indian investors can apply regardless of experience or portfolio size.
Know Your Own Risk Capacity
Risk management has its genesis in the introspective honesty of one’s temperament. Risk capacity is largely dictated by the flow of one’s income, financial liabilities, age and horizon. Whereas a young professional with a stable income and no long-term financial commitments can bear a greater degree of deviation in the portfolio, the same may not be said for a post-retirement saver with a limited and shrinking corpus.
Risk attitude is a matter of one’s psychological temperament. Whereas a few people can stomach a dip in the value of their portfolio without panicking, others will find themselves emotionally and physically constricted at every modest loss. Being honest with oneself helps identify an optimal mix which not only reflects one’s financial requirements but also leaves one mentally soothed. A portfolio which provides solace may not always provide the maximum returns, but the stress and anxiety of the markets at their worst can drive one to rash decisions at the worst of times.
Spread It Thin And Let It Go
Concentration is among the prime culprits behind preventable losses. Divesting the risk across different classes-equity, debt, gold, cash-creates a protective umbrella against unforeseen disappointments. Within equity, it is prudent to diversify across sectors, market capitalisation, and styles. Investors in India have a natural affinity for gold and real estate. Whereas a small exposure to gold is bound to provide some comfort during a steep fall in equities, fixed income instruments such as treasury notes, high-grade corporate bonds or term deposits would provide consistent, reasonably sustainable returns.
In each case, the allocation should be in consonance with the requirements. It goes without saying that no single exposure should dictate the terms of the entire portfolio.
Think Big, But Stay Small: Stop Losses And Position Sizes
For active trading, position size is hands-down the most crucial risk management tool. As its very name suggests, it limits the risk in every trade. By exposing just a minuscule proportion of the portfolio in any one trade, one limits the losses in any arbitrary series of missteps. Many a trader today sticks to a strict policy that no trade shall expose more than a pre-determined small percentage (say 3-5 percent) of the total portfolio at risk.
Stop loss orders can be useful in plugging this in the absence of the necessary temperament. However, their use has to be tempered with caution, lest the frequent whipsaw oscillations induce unnecessary panic. The stop-loss level must be set in accordance with the likely volatility of the scrip. Set too tight, it wil lsee the investor off at the slightest dip; too loose, and the entire rationale breaks down. Besides, in certain market conditions, especially with derivatives, the stop-loss could trigger a sale at a much lower price
Longer term investors have no need to use stop-losses or even track the day-to-day movements of the stock unless there is a palpable change in fundamentals. Instead, they can simply rebalance the portfolio to reflect changing conditions, selling certain holdings that no longer meet their criteria while buying others.
Keep It Liquid, But Avoid Leverage
Maintaining a cash-cushion is also a helpful way of managing risk. It reduces the temptation of having to book losses in equities to raise funds in case of an emergency. In addition, it provides liquidity and psychological relief. If one knows that there is a back-up in cash to tide over temporary setbacks, one is less likely to sell equities in an anxious fit of panic. A cash reserve which covers 6-8 months of expenses can serve as a useful buffer against the ebb and flow of the markets. On the other hand, leverage should be avoided; it magnifies returns as well as losses and the latter can be catastrophic. Derivatives, especially option-writing, entails a significant degree of risk in terms of time decay and volatility. If one wishes to dip into these, it is absolutely necessary to understand the mechanics as well as one’s own temperament.
Insurance Covers Unforeseen Emergencies
Many investors overlook the role of insurance as a critical risk management tool. An appropriate health and term life cover goes a long way in protecting their financial needs at a time of distress. Unless covered by insurance, it makes little sense for investors to tie up corpus in liquid assets to cover medical expenses since such a move would entail crystallising losses in the process.
Guard The Psychology
Much of risk management is devoted to tempering expectations and avoiding rash action. Investors must avoid the temptation to track the markets constantly, especially in times of heightened volatility. Instead, they should stick to a pre-set schedule of tracking their portfolio. A written investment plan that outlines objectives, allocations and risk parameters can be a calming aid during periods of turmoil.
Reviewing the plan periodically and rebalancing the portfolio on a pre-determined schedule will encourage a contrarian approach; say, selling some high flyers and buying low ones in anticipation of a turnaround.
Take Advantage Of Volatility
Though many find uncertainty and stress, market volatility provides certain advantages. First and foremost, it offers value opportunities for investors so prepared. At the same time, systematic investing helps take advantage of these dips. The lower prices during volatile times enable systematic investors to augment their portfolio at little extra cost.
While market ups and downs can seldom be controlled, the investor can focus on the preservation of capital with an eye on long-run gains. By employing simple risk management techniques, investors can protect, preserve and even profit from volatile market swings.
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