Risk in Stock market management

Identify factors why mostly lose money in stock market? How to minimize them all? Risks of investing in stocks:
1) Systematic risk 2) Non-systematic Risk 3) Inflation risk 4) Market risk 5) Interest-rate risk 6) Liquidity risk 7) Global risk 8) Sector risk 9) Equity specific asset risk 10) Timing Risk 11) Speculative Risk 12) Contagion Risk 13) Tax risk 14) Economic risk 15) Political risk 16) Emotional risk Systematic Risk: Systematic risk is defined as a risk to an entire financial system. If the entire system goes through a shock or collapse even broad based index funds will suffer and the melt down can go through multiple asset classes simultaneously. Diversification can help and hedging can definitely help control systematic risk. Owning long put option contracts or inverse funds can be one of the best ways to hedge against systematic risk. Non-systematic Risk, or Company Specific Risk: Non-systematic risk also known as company specific risk can be diversified away. It is the risk of one company failing due to multiple reasons including product failure, lawsuits, fraud, etc. Wall Street's history is full of stories of companies that were substantial at one time failing completely. WorldCom was the second largest long distance carrier in the US behind only AT&T; Enron was one of the world's leading energy companies. Both stocks imploded and became worthless. Company specific risk can be reduced by using broad based index funds. Inflation Risk: Inflation risk is one of the worst types of risk an investor can face. Though not as shocking to a portfolio as a market crash, the steady erosion of your purchasing power over time can have devastating long term effects. The way to combat inflation risk is to invest in securities whose return exceeds the rate of inflation, which means investing in equities. Adding commodities to a portfolio can be a good inflation risk hedge because many commodities can keep pace with inflation. An inflationary period combined with a market crash can be especially devastating to a
1|Page

portfolio. The value of an equity portfolio can decline dramatically at a time when an investor needs extra funds to keep up with inflation. Market risk: Market risk is the risk that the value of your investment decline. This may happen for several reasons: The market in which you are investing may decline, The area of investment you selected may be out of fit The price of your investment may decline for reasons specific to your investment The market risk is more relevant in the short term. Interest-rate risk: Interest rate risk is the risk of a decline in the value of your investments when interest rates increase. Most of your fixed income investments will decline in value when interest rate increase and the value of common stocks will generally also decline. The inflation risk is an important consideration in long term investments. Liquidity risk: Liquidity risk is the risk that you will be unable to convert your investments to cash. Stated another way, liquidity is ability to sell your investment at a fair price. Liquidity risk can occur in any type of investment not have a well-established market. Some stocks have very few shares outstanding and buying or selling it will cause a large price movement. You may even find instances where there are virtually no buyers for a stock or bond you own you just have to hold your investment. Global risk: This is the vulnerability of an investment to international events or market factors. This would include movements in exchange rates, changes in trade or tariff policies and changes in international or bond markets. Affect the prices of the listed securities. Sector risk: The risks associated with an industry's specific products or services such as, demand for the product or service; commodity prices; the economic and industry cycles; changes in consumption patterns; lifestyle and technology changes. This may be minimised by detailed research to identify quality investments, reviewing their performance and their place in a portfolio. Equity specific asset risk: Risks associated with the specific investment, for example, quality of the company's directors; the strength of management and key personnel; profitability and asset base; debt level and fixedcost structure; litigation; competition levels; liquidity of the investment. Timing Risk: It is the possibility that you enter the market at a bad time for example, just before a fall in the share market. This can be minimized by not investing all of your funds into the market at one time.

2|Page

Speculative Risk: If an investment is described as speculative you should be aware that the investment could rise significantly but also fall by the same degree. You should not invest in speculative investments unless you understand and accept the risks fully and are prepared to accept any resultant loss. Contagion Risk: Contagion risk is similar to systematic risk but is defined as a scenario where one financial event leads to another which eventually leads to a meltdown. The US subprime crisis of 2008 as first appeared to be limited to the US housing market, but eventually spread to lending liquidity, bank reserve requirements and went overseas to Europe and Asia. Stocks plunged and investors fled to safe investments like US Treasuries. Contagion can be diversified to some extent by holding treasuries and other safe havens investments in your portfolio and by hedging. Economic risk: Economic risk refers to how your investments perform over the course of economic cycles. During a recession (a temporary decline in economic activity), the prices of your common stocks and many of your other investments probably will decline. Some investments will decline more than others; for example, stocks of industrial companies will decline because the companies will generally not be earning as much as when the economy is in an up cycle. Other investments, such as government bonds, are less sensitive to economic cycles, or not sensitive at all. Conversely, when the economy is performing well and corporations are earning better than expected profits, your common stocks and similar investments generally will perform well. Political risk: Sometimes referred to as legislative risk, is the effect a political or legislative action can have on your income and the value of your investments. Tax changes are the most significant political risk that affect you, whether you invest or not. Every time income, sales, or Social Security taxes are decreased, your after-tax income increases. Political risk can take other forms as well. The Arab oil embargo in the early 1970s caused the price of oil to increase by almost six times. Many companies that used oil in the manufacture of their products had a sharp increase in their cost of goods, affecting their profits and, in turn, their stock prices. Regulatory changes are another political risk. An increase in regulation may create more red tape, reduce profitability, and hurt your investment. Deregulation can help or hurt. If it promotes efficiency, profits and stock value could rise. But if it causes more competition at lower prices, companys profits drop and, in turn, their stock prices will decline. Tax risk: Taxes (such as income tax or capital gains tax) dont affect your stock investment directly. Taxes can obviously affect how much of your money you get to keep. Because the entire point of stock investing is to build wealth, you need to understand that taxes take away a portion of the wealth that youre trying to build. Taxes can be risky because if you make the wrong move with your stocks (selling them at the wrong time, for example), you can end up paying higher taxes than you need to. Because tax laws change so frequently, tax risk is part of the risk-versus-return

3|Page

equation, as well. It pays to gain knowledge about how taxes can impact your wealth-building program before you make your investment decisions. Emotional risk: What does emotional risk have to do with stocks? Emotions are important risk considerations because the main decision makers are human beings. Logic and discipline are critical factors in investment success, but even the best investor can let emotions take over the reins of money management and cause loss. For stock investing, youre likely to be sidetracked by three main emotions: greed, fear, and love. You need to understand your emotions and what kinds of risk they can expose you to.

Common risks of a stock market:

Lose of money: Stock market risk management is one of the most difficult skills for an investor to master. Investing in the stock market is fraught with worry, for good reason. If you lose half of your investment, you must double your return to just breakeven. Warren Buffett, considered by many to be the worlds greatest investor, states his first rule of investing is do not lose money. Unfortunately, the risk in the stock market of losing your money is always a possibility. However, without taking some risk there is no reward. Therefore, successful investors employ stock market risk management strategies to minimize their losses. Market trend Risk: Risk in the stock market comes in many forms and each can lead to a loss. The most common is the overall trend of the market. Approximately 60 % of the move of an individual stock is attributed to the trend of the stock market. If the stock market is rising, it takes with it most of the other stocks, though not in equal amounts. When the stock market falls, stocks sink with it. Timing the Market: Another risk that buyers of common stock assume has to do with market timing. For example, you might buy a stock at the peak of an upswing in price. In fact, many times this fear of "buying high and selling low" keeps investors away from the market. With this type of risk, we're talking about both macro and micro effects associated with buying stocks. For example, the stock market itself could be at the end of a bull market, and the entire market is about to experience a cyclical downturn. On the other hand, an individual stock might have reached its earnings peak, and is about to start a decline. An investor can never be certain if a bull market has run its course or if it's going to continue for several more years. The same holds true for a company's stock. While the stock price might be at an all time high, that doesn't necessarily mean it's not going higher. In this example, the risk an investor wants to protect themselves against is a downturn in prices. Individual stock risk: Another big risk in the stock market lies with owning an individual stock. While owning the stock of a company can offer greater rewards, it also entails the risk that something might go wrong that can cut the price of the companys shares in half. It might be news that sales have

4|Page

suddenly fallen due to a new competitor, or a product liability issue has arisen. For whatever the reason, individual stocks are subject to risk associated to them alone.

Market trend risk Lose of money in stock market

Invest by seeing the market trend Longterm investment

Market timing risk Individual stock risk

Diversification Stick market risk management

Figure1: major Risks and how to mitigate the risk

Strategies to mitigate stock market Risks:

Diversifying your holdings is one of the best ways to address the risk associated with holding individual stocks. . Part of managing stock market risk is being on the right side of the trend. We can prevent lose of money in stock market by proper stock market risk management. . Managing risk in stock market starts with identifying the type of risk and taking action to mitigate the impact of the risk on your investment portfolio. I. Trend risk management: They can invest with the trend of the market. Following the trend is a proven method to help manage the risk of the stock market, though it is not as easy as it sounds. This trend following tries to identify and then align with the underlying trend of the market. The assumption is the market will be in a trend that could last a day, a week, a month a year or multiple years. Generally, short-term trends cycle within longer term trends. Depending on your time frame, you can align your stock position with the trend once you have identified it. When you follow the trend, you are able to reduce the likelihood your stock will fall when the market trend is rising. Individual Risk management: Risk management strategy for owning stocks is to diversify your portfolio across several different companies, sectors, and asset classes. By owning several different stocks, you reduce the impact of a loss in any one company. Moreover, if the stocks you own are

II.

5|Page

from several different industry sectors you mitigate the impact of any one sector causing a loss. III. ETF availability to reduce stock market Risk: Exchange Traded Funds (ETFs) offer an excellent way to add diversity to your portfolio, as they hold shares of companies based on an index. The index can be for the whole market, or any segment of the market. When using ETFs, be sure there is sufficient liquidity (plenty of shares trading) or you will create another unwanted risk. Long Term Investing Horizon: The third, and final, technique we're going to discuss for controlling risk has to do with your investment timeline. This is a strategy you can use to help lower the risk associated with timing the market. The last thing any investor wants to do is buy high and then be forced to sell low. There is no doubt that the stock market is subject to short-term fluctuations, and even longer-term bear markets. But over the long term, the stock market has traditionally turned in a strong performance in terms of return on investment. For example, the S&P 500, a widely accepted indicator of the overall market performance, provided an average annual return in excess of 9% in the ten years from 1995 through 2006. While past performance is certainly no guarantee of future performance, by adopting a long-term investment planning horizon, you can minimize the risk of relatively shortterm market downturns. Less Risky Stocks Certain securities are deemed safer investments--that is, reputable companies with track records of both stable earnings and minimal liabilities. They have long been referred to as blue-chip stocks. And while some former blue-chip stocks, including GM and Citibank, proved unworthy of the designation, it's still a savvy investment strategy to maintain a sampling of the best-capitalized companies' stocks in your portfolio. For information on these companies, peruse the Financial Times Global 500 via ft.com. Most of these corporations pay regular dividends to their stockholders. And while they are unlikely to surprise you with colossal share price gains in any given year, abrupt declines in value are equally improbable. Over the long term, including steady---but reasonably certain---gainers in your investment portfolio enhances your prospects of profiting in the end. Companies repeatedly on the Financial Times Global 500 listing include IBM, Walmart, Coca-Cola and Exxon-Mobil. Cost Averaging: The concept of cost averaging encourages you, the investor, to buy securities when the market is at low ebbs. By purchasing undervalued stocks when prices are depressed, you buttress your long-term portfolio performance because the average cost per share in your aggregate investment decreases, which is---optimally---what you want. Stop Loss: Stop loss or trailing tool is yet another device to check that you dont lose money should the stock go far a fall. In this strategy the investor has the option of making an exit if a
6|Page

IV.

V.

VI.

VII.

certain stock falls below a certain specified limit. Self-discipline is yet another option employed by some investors to sell when the stock falls below a certain level or when there is a steep fall. VIII. Options: Many people believe equity options are risky investments. It is true that options can be risky as they increase your use of leverage. However, professional investors use certain options to reduce the risk of their portfolios. Covered call options are an excellent way to create some down side protection while increasing the potential return of your portfolio. Covered calls are suitable for IRA accounts, indicating that the authorities consider them a low risk investment strategy. Protective put options are another method to lower risk of a portfolio. Similar to insurance, protective puts provide security should your long positions suddenly fall in price. When that happens the put option guarantees you will receive the agreed upon price for your stock no matter how far it falls. You can learn more by reading articles on covered calls and protective puts that describe the features and benefits of these stock market risk management strategies. Short selling: When the market trend shows that the prices are going down there is a possibility that we can benefit from this by the help of short selling.

IX.

Risk management process in stock market:

7|Page

I.

Identification of potential risk:

The two major potential categories to identify are systematic and unsystematic risk. Systematic risk is associated with market returns. These are risks that are affected by macroeconomic factors that affect the market as a whole. These would include changes in interest rates, inflation, recessions, war, etc. Unsystematic risk is company specific or industry specific risk. This is risk specific to the individual investment or small group of investments and is uncorrelated with stock market returns.

II.

Assessment of the magnitude and probability of those risks occurring:

After identifying risks the next step is to assess the potential damage and the probability of the risk occurring. Systematic risk, or market risk, can be estimated from historical data. We can measure the volatility and frequency of market declines and estimate the damage and probability of that damage fairly accurately over a long period of time. Unsystematic risk, or specific risk, requires a great deal of analysis for an individual investment because of the hundreds, or even thousands, of risk factors that could influence a company or industry.

III.

Choosing a path or technique to optimize the risks and rewards of the portfolio:

Once identification and assessment are completed, there are 4 major risk management decision choices: 1. Avoid eliminate or withdraw from investment choice. 2. Control mitigate or optimize through action. 3. Transfer outsource through hedging or insurance 4. Accept make the investment knowing the risks Avoiding and accepting risks are fairly straightforward decisions. The other two decisions, control and transfer, require further decision making. First priority should be to mitigate unsystematic or specific risk because it is the easiest and offers the largest benefits of risk management. If a portfolio consists of just a few stocks the entire portfolio can suffer severe damage if one stock experiences a large decline. However, a portfolio that consists of many stocks would suffer minimal damage from the decline of one stock. Diversification can nearly eliminate specific risk from a portfolio. Systematic risk, or market risk, is not quite as easy to mitigate. Some investors may choose financial hedging; others may choose to partially avoid some market risk by increasing their asset allocation to fixed income or cash. As Portfolio Manager of the Arbor Asset Allocation Model Portfolio (AAAMP) I employ an active or tactical asset allocation strategy.

Risk Management for a Trade:

Before you decide to trade consider to these fundamental principles: Before you trade a stock, know how much you are willing to lose. Check the stock to be sufficiently liquid, can you buy or sell promptly? Determine the cut-loss level before trading. Determine your profit target (take-profit-level).
8|Page

Buy the stock only at an acceptable price level. Use a limit order when you buy a stock. Immediately after the trade has been confirmed, enter the stop-loss-at- market order at your predetermined stop-loss level. Take profit when the trade reaches your profit target. For example: so many traders determine their cut-loss level 2% of their capital and they call it 2% rule. If you own 1000 shares of X at $100 with a $2 stop loss order in place, your risk is: $2 * 1000 = $2,000. So long as you have capital amounting to at least $100,000 on hand, you would not be considered to be in breach of this "rule".

Portfolio Risk Management:

Whit managing the risk of each trade your portfolio risk will be well under control and you manage your portfolio risk actively, but to control your portfolio risk management better notice to these points: Determine your overall cut-loss level. Usually your portfolio should not lose more than 10% of your capital. Diversify your investment in at least six or more different stocks. Know your overall risk tolerance before building up the portfolio. Act quickly when you see your risk limits exceeded. Close out the entire portfolio if it loses to your overall stop-loss level.

Benefits of Risk Management in Stock Market:

The biggest benefit of risk management in stock market is portfolio optimization of risk and reward. A portfolio manager, willing to take a given amount of portfolio risk, can purchase individual higher reward/higher risk investment because risk management techniques lower overall portfolio risk. In other words, risk management allows a portfolio manager to place more aggressive assets in a portfolio without increasing, risk exposure for the whole portfolio.

9|Page