When it comes to various financial instruments, Risk and Return go hand-in-hand. Every security has a risk and return trade-off associated with it — usually, the more the underlying risk involved, the higher the proportion of returns that are likely to occur in the future.
We'll briefly cover risk here, but will go into more detail in a later tutorial.
Risks can be divided broadly into two types:
Also known as “Diversifiable Risk”, it is the risk which an asset or security carries due to the industry’s or company’s performance in general. For example, if you have a stock portfolio with 5 stocks in it, two of which are prone to Unsystematic Risk, your portfolio can still give healthy returns given that the remaining three stocks are still performing well.
Diversification is the act of “Not putting all your eggs in one Basket.”
If you have a stock portfolio, try and diversify with stocks from different sectors or in companies which have consistency in their performance.
Diversification can be done in different assets classes as well. For example, a portfolio with 80% equity and 20% debt instruments can be a prudent investment decision, especially in a high growth environment. The percentage of debt instruments may need to increase during recessionary times to offset the risks associated with holding equities.
In contrast, this risk is termed as the “Non-Diversifiable Risk”. As an example, imagine that you strongly believe in the Banking sector in the US and think that it is performing extremely well and will continue to do so. You want to add stocks to your portfolio, so you get 3 stocks from the banking sector and maybe another 2 from some other sector like Technology. Hence your portfolio consists of Bank of America, Citigroup, JP Morgan, Apple and Amazon. The following week, the US Government passes a regulation impacting profits of all major banks, financial institutions and technological companies in the country.
Now what do you do? You are at a loss since you have nothing to rely on and your entire investment takes a hit, thus dramatically impacting your finances. The risk that emerges out of a market force or government regulation which is equal for all sectors and the affect of which cannot be mitigated even after diversification is Systematic Risk.
- Unsystematic risk is associated with a particular industry or security, is controllable via diversification and arises due to microeconomic factors.
- Systematic risk is associated with the whole market or market segment, is uncontrollable, and arises due to macroeconomic factors.
Returns are the capital appreciation that one looks for when making investments. New investors can lower their risk by diversifying their portfolio with some Equity (stock) and Debt (bonds, debentures) instruments. As discussed previously, equity investments are prone to risk — this is why they reap hefty returns for investors (if the stock-picking exercise is backed by proper research). In contrast, debt instruments have the least or zero risk, while providing minimal return.
The higher the risk, the higher is the possibility of garnering huge returns. Hence, if you are successful in identifying sound companies with strong stock performance, you can balance the risk that goes with it. Instruments which are backed by government have limited exposure to market and hence the least risk. Different assets are prone to different amount of risks and the trading techniques followed make a huge impact on the trade-off between the two.
Figure 2: Risk vs Returns for Different Assets (Quantified for data between 1970-2010)
A quantifiable measure that is used to assess market risk for a stock is often used by analysts and it is known as beta (β). The beta for a stock helps an investor compare the performance of the stock to that of the market. In case the beta is greater than one (>1) the stock is said to outperform the market both in terms of risk and returns, while if the same is less than one (<1) the stock is predicted to under-perform or fall short of market expectations.
It is important to understand the two major trading styles and see what style suits you the best.
Making long term investments by conducting research or doing short-term trading are two contrasting actions of an individual in the stock market. An investor is one who aims at building long term wealth while shuffling securities in his/her portfolio. A strikingly different method is followed by traders where securities in a portfolio are closely monitored and the investments are carried out on a short term basis (for less than a year). Oftentimes traders are also involved in speculation and swift entry and exit from the market. These traders often engage in frequent trading of stocks and use many technical tools to help them pick their positions.
Let’s consider a few examples to understand how these different investment techniques or ideologies functions:
- Kevin and Adam and two individuals with a lot of inclination towards equity investments (the scenario can be seen in the Futures & Options market as well but we will restrict to equity investments as an example).
- On one hand, Kevin always picks a stock after conducting exhaustive research on the company and estimating how well the stock will perform in future — he is thus able to make healthy profits 80% of the times. He takes calculated risks in all his equity investments and his portfolio has always been for a longer duration of time (ranging for 7-10 years).
- Adam on the other hand is a trader who loves to trade stocks based on past trends. He conducts research either on the company or its management and buys stock to make some quick money. His success rate is somewhere in the range 70-75% and he is well aware of how market forces can help him make quick money.
- While Kevin is an Investor with a sound investment technique in place with a motive to build a long term wealth portfolio, Adam follows a different technique. He may do some research on stocks but since he remains invested for a shorter duration, his strategy is short-term based.
Traders usually function on a shorter time horizon. They are classified based on the amount they are trading and the time they remain invested for. They rely on a lot of technical tools, like Moving Average of stock price for a 20 or 50-day period and prepare a robust portfolio of securities based on this analysis.
Since investors will generally buy and hold their positions, they can weather bad market conditions, but traders generally have protective stop orders that will automatically sell their stocks at a particular loss (ie. if the stock drops by 20% for example).
- Position Trader: Traders which have taken position in a stock and remain invested between a few months to some years.
- Swing Trader: Those traders who remain or shuffle their portfolio quite frequently between week or days are regarded as swing traders
- Day Traders: Positions are specifically held for the day and a profit or loss is calculate as the markets close.
Firms also indulge in short term trading to book massive profits especially in commodities or in short terms contracts. Short term investors are primarily the ones who own a security for a few months (less than a year) and sell the stocks once profits are booked. The same can be a fruitful exercise if a prosperous event surrounds the company’s financials and is reflected in the stock price.
For example, if I have some insight into the Technology Sector and I feel Apple Inc. is coming up with amazing “quarterly revenue numbers” after a wonderful response for iPhone X in the market, the how would I as a trader reap profits? I would buy the stock at lower levels and hold the stock until I make substantial profit and then sell the stock. This way I was a part of a “stock rise” and made my share of profits and exited when a subsequent stagnancy in stock price began. Similarly, day traders make use of some uncanny events surrounding a stock and exit after making profits. This usually requires a lot of practice and insights into how a stock might perform.
Since a large percentage of day trading is generally algorithmic high frequency trading by trading firms, it is generally not advantageous for individual investors to do day trading unless they are heavily trained and understand all the tools and risks. For a beginner it might be better to take a longer term view on various sectors / companies and bet that they will do well in the future — i.e. take the investing approach, especially given that day trading is also emotionally challenging.