How we manage risk in client portfolio

When one invests in stocks, there are primarily two risks faced by an investor. First is the risk of loss of capital and the second is the risk of the investment performing poorly compared to the broad market index.

So how do we manage these risks in our investing strategy? Let’s look at risk of loss of capital first. Here it is important to differentiate between a temporary loss of value of an investment due to market fluctuations and a permanent loss of capital.

A permanent loss of capital occurs when the stock in which the money is invested goes bust due to poor management, unfavorable business cycle and poor corporate governance resulting in companies going bankrupt. Recent examples of such companies are Kingfisher Airlines, DHFL. Such a risk is inherent when investing in stocks, which is why it is important to invest in well researched diversified portfolio of stocks.

Another reason for an investor to suffer permanent capital loss is when an investor uses leverage in his investments. For example if an investor who has Rs 10 lakhs to invest, buys stocks worth Rs 30 lakhs using margin trading facility, even a 10% decline in value of stocks is enough to wipe out 30% of investor capital.

To mitigate this risk, when a constructing a portfolio for a client we allocate bulk of the capital towards an index fund, such as Nifty 50 Index Fund, or high quality blue chip stocks. Further the investment is made to the extent of capital introduced by the client, thus avoiding any leverage at all. In such a portfolio, any fall in value due to market corrections, is bound to be temporary and as the market rebounds from lows, so does the value of index funds and other stocks.

The second risk of underperforming the market occurs when the stocks or sectors in which an investment is made go through a downturn while the rest of the economy/market is performing well. This happens due to either over concentration in a few stocks or poor stock selection, resulting in poor investment returns compared to the returns provided by the broad market.

As mentioned above, bulk of the client’s capital is allocated to an index fund, which is itself a diversified portfolio of stocks representing various sectors of the economy. Thus the client is assured of returns that are in line with broad market returns. Further, when we employ our income generating strategies to earn additional return, the capital allocated to such strategies forms a minuscule component of client capital. This ensures minimum impact on portfolio returns while also generating portfolio income.