Module 9 Risk Management & Trading Psychology

Chapter 2

Risk (Part 1)

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2.1 – Warming up to risk

For every rupee of profit made by a trader, there must be a trader losing that rupee. As an extension of this, if there is a group of traders consistently making money, then there must be another group of traders consistently losing money. Usually, this group making money consistently is small, as opposed to the group of traders who lose money consistently.

The difference between these two groups is their understanding of Risk and their techniques of money management. Mark Douglas, in his book ‘The Disciplined Trader’, says successful trading is 80% money management and 20% strategy. I could not agree more.

Money management and associated topics largely involve assessment of risk. So in this sense, understanding risk and its many forms become essential at this point. For this reason, let us break down risk to its elementary form to get a better understanding of risk.

The usual layman definition of risk in the context of the stock market is the ‘probability of losing money’. When you transact in the markets, you are exposed to risk, which means you can (possibly) lose money. For example, when you buy the stock of a company, whether you like it or not, you are exposed to risk. Further, at a very high level, risk can be broken down into two types – Systematic Risk and Unsystematic Risk. You are automatically exposed to both these categories of risks when you own a stock.

Think about it, why do you stand to lose money? Or in other words, what can drag the stock price down? Many reasons as you can imagine, but let me list down a few –

  1. Deteriorating business prospects
  2. Declining business margins
  3. Management misconduct
  4. Competition eating margins

All these represent a form of risk. In fact, there could be many other similar reasons and this list can go on. However, if you notice, there is one thing common to all these risks – they are all risks specific to the company. For example, imagine you have an investable capital of Rs.1,00,000/-. You decide to invest this money in HCL Technologies Limited. A few months later HCL declares that their revenues have declined. Quite obviously HCL stock price will also decline. Which means you will lose money on your investment. However, this news will not impact HCL’s competitor’s stock price (Mindtree or Wipro). Likewise, if HCL’s management is guilty of any misconduct, then HCL’s stock price will go down and not its competitors. Clearly, these risks are specific to this one company alone and not its peers.

Let me elaborate on this – I’m not sure how many of you were trading the markets when the ‘Satyam scam’ broke out on the morning of 7th January 2009. I certainly was, and I remember the day very well. Satyam Computers Limited had been cooking its books, inflating numbers, mishandling funds, and misleading its investors for many years. The numbers shown were way above the actual, myriads of internal party transactions; all these resulting in inflated stock prices.  The bubble finally burst, when the then Chairman, Mr.Ramalinga Raju made a bold confession of this heinous financial crime via a letter addressed to the investors, stakeholders, clients, employees, and exchanges. You have to give him credit for taking such a huge step; I guess it takes a massive amount of courage to own up to such a crime, especially when you are fully aware of the esnuing consequences.

Anyway, I remember watching this in utter disbelief –  Udayan Mukherjee read out this super explosive letter, live on TV, as the stock price dropped like a stone would drop off a cliff. This, for me, was one of the most spine-chilling moments in the market, watch the video here –

I want you to notice few things in the above video –

  1. The rate at which the stock price drops (btw, the stock price continued to drop to as low as 8 or 7)
  2. If you manage to spot the scrolling ticker, notice how the other stocks are NOT reacting to Satyam’s big revelation
  3. Notice the drop in the indices (Sensex and Nifty), they do not drop as much as that of Satyam.

The point here is simple – the drop in stock price can be attributed completely to the events unfolding in the company. Other external factors do not have any influence on the price drop. Rather, a better way of placing this would be – at that given point, the drop in stock price can only be attributable to company specific factors or internal factors. The risk of losing money owing to company specific reasons (or internal reasons) is often termed as “Unsystematic Risk”.

Unsystematic risk can be diversified, meaning instead of investing all the money in one company, you can choose to invest in 2-3 different companies (preferably from different sectors). This is called ‘diversification’. When you diversify your investments, unsystematic risk drastically reduces. Going back to the above example, imagine instead of buying HCL for the entire capital, you decide to buy HCL for Rs.50,000/- and maybe Karnataka Bank Limited for the other Rs.50,000/-, in such circumstances, even if HCL stock price declines (owing to the unsystematic risk) the damage is only on half of the investment as the other half is invested in a different company. In fact, instead of just two stocks, you can have a 5 or 10 or maybe 20 stock portfolio. The higher the number of stocks in your portfolio, higher the diversification, and therefore lesser the unsystematic risk.

This leads us to a very important question – how many stocks should a good portfolio have so that the unsystematic risk is completely diversified. Research has it that up to 21 stocks in the portfolio will have the required necessary diversification effect and anything beyond 21 stocks may not help much in diversification. I personally own about 15 stocks in my equity portfolio.

The graph below should give you a fair sense of how diversification works –

As you can notice from the graph above, the unsystematic risk drastically reduces when you diversify and add more stocks. However after about 20 stocks, the unsystematic risk is not really diversifiable, this is evident as the graph starts to flatten out after 20 stocks.  In fact, the risk that remains even after diversification is called the “Systematic Risk”.

Systematic risk is the risk that is common to all stocks in the markets. Systematic risk arises out of common market factors such as the macroeconomic landscape, political situation, geographical stability, monetary framework etc. A few specific systematic risks which can drag the stock prices down are:–

  1. De-growth in GDP
  2. Interest rate tightening
  3. Inflation
  4. Fiscal deficit
  5. Geopolitical risk

The list, as usual, can go on but I suppose you get a fair idea of what constitutes a systematic risk. Systematic risk affects all stocks. Assuming, you have a well diversified 20 stocks portfolio, a de-growth in GDP will indiscriminately affect all the 20 stocks and hence the stock price of stocks across the board will decline. Systematic risk is inherent in the system and it cannot really be diversified. Remember, ‘unsystematic risk’ can be diversified, but systematic risk cannot be. However, systematic risk can be ‘hedged’. Hedging is a craft, a technique one would use to get rid of the systematic risk. Think of hedging as carrying an umbrella with you on a dark cloudy day. The moment, it starts pouring, you snap your umbrella out and you instantly have a cover on your head.

So when we are talking about hedging, do bear in mind that it is not the same as diversification. Many market participants confuse diversification with hedging. They are two different things. Remember, we diversify to minimise unsystematic risk and we hedge to minimise systematic risk and notice I use the word ‘minimise’ – this is to emphasise the fact that no investment/trade in the market should be ever considered safe in the markets.

Not mine, not yours.

2.2 – Expected Return

We will briefly talk about the concept of ‘Expected Return’ before we go back to the topic of Risk. It is natural for everyone to expect a return on the investments they make. The expected return on an investment is quite straight forward – the return you would expect from it. If you invest your money in Infosys and expect to generate 20% return in one year, then the expected return is just that – 20%.

Why is this important especially when it sounds like a no-brainer? Well, the ‘expected return’ plays a crucial role in finance. This is the number we plug in for various calculations – be it portfolio optimisation or a simple estimation of equity curve. So in a sense, expecting a realistic return plays a pivotal role in investment management. Anyway, more on this topic as we proceed. For now, let us stick to basics.

So continuing with the above example – if you invest Rs.50,000/- in Infy (for a year) and you expect 20% return, then the expected return on your investment is 20%. What if instead, you invest Rs.25,000/- in Infy for an expected return of 20% and Rs.25,000/- in Reliance Industries for an expected return of 15%? – What is the overall expected return here? Is it 20% or 15% or something else?

As you may have guessed, the expected return is neither 20% nor 15%. Since we made investments in 2 stocks, we are dealing with a portfolio, hence, in this case, the expected return is that of a portfolio and not the individual asset. The expected return of a portfolio can be calculated with the following formula –

E(RP) = W1R1 + W2R2 + W3R3 + ———– + WnRn

Where,

E(RP) = Expected return of the portfolio

W = Weight of investment

R = Expected return of the individual asset

In the above example, the invested is Rs.25,000/- in each, hence the weight is 50% each. Expected return is 20% and 15% across both the investment. Hence –

E(RP) = 50% * 20% + 50% * 15%

= 10% + 7.5%

= 17.5%

While we have used this across two stocks, you can literally apply this concept across any number of assets and asset classes. This is a fairly simple concept and I hope you’ve had no problem understanding this. Most importantly, you need to understand that the expected return is not ‘guaranteed’ return; rather it is just a probabilistic expectation of a return on an investment.

Now that we understand expected returns, we can build on some quantitative concepts like variance and covariance. We will discuss these topics in the next chapter.


Key takeaways from this chapter

  1. When you buy a stock you are exposed to unsystematic and systematic risk
  2. Unsystematic risk with respect to a stock is the risk that exists within the company
  3. Unsystematic risk affects only the stock and not its peers
  4. Unsystematic risk can be mitigated by simple diversification
  5. Systematic risk is the risk prevalent in the system
  6. Systematic risk is common across all stock
  7. One can hedge to mitigate systematic risk
  8. No hedge is perfect – which means there is always an element of risk present while transacting in markets
  9. Expected return is the probabilistic expectation of a return
  10. Expected return is not a guarantee of return
  11. The portfolio’s expected return can be calculated as – E(RP) = W1R1 + W2R2 + W3R3 + ———– + WnRn

62 comments

  1. RITUKANT MAURYA says:

    Very nicely defined unsystematic & systematic risk. expecting more topic to be covered in one chapter. eagerly waiting for next chapter.

  2. Vikas Gupta says:

    Please share the list of 15 stocks.

  3. Ankit says:

    Hi Sir
    Sir I have general question regarding Risk
    I have read some comments on Internet of experts
    Some say that selling of OTM call options has least risk if right strike price is chosen
    Is it true?

    • Karthik Rangappa says:

      Ankit, to some extent it is true, but not always. Strike selection should be a result of your assessment of market condition.

  4. Sai Sreedhar says:

    We tend to always think that Risk is synonyms with loss/negativity. While in reality we have two sides of the coin – negative risk as you have explained and there is positive risk, and both have different methods of handling, which I am sure you might cover in module further.

  5. Maddy says:

    Why are you so slow in putting up new lessons? 🙁
    And why no pdf of previous module?

    • Karthik Rangappa says:

      Sorry Maddy, I find it a challenge to structure and simplify content. Hence I tend to take time to put us stuff. Note, these are original content, NONE of the content in Varsity is plagiarized, I can assure you that. There are times when I write stuff, scrap it completely because I’m not happy with it and I rewrite. Such things consume time.

      Will put up the PDFs soon.

      • Maddy says:

        I have no words to express my gratitude. The varsity articles are gems, off course.
        Can you suggest some book/pdfs esp with trading (no investing) perspective.
        Want to learn trading asap
        TIA

  6. Gurpreet says:

    Karthik and team zerodha, you guyz are doing an awesome job putting up the best pieces of information and advice on stock markets. Eagerly waiting for all the next chapters in this and all future modules…. 🙂

  7. Subbu says:

    Sir, in your module on options strategies, you mentioned that there are some 300-400 option strategies in the public domain. Where can I find the complete list? I’am just curious

  8. deep24 says:

    plzzzzzzzzzzzzzzzzzz
    update stretegies section cant wait more..

  9. MSP says:

    Hi Karthik,

    Futures, i am long on a specific stock today of 2000 lot, and stock is trading above resistance and above all moving averages, how the hedging could be done in this case.

    Regards,
    MSP

  10. ankur says:

    hi
    when we can expect module 10 trading strategies and system.i am eagerly waiting for it..also please recommend some good books related to it

  11. sat says:

    great explanation sir…on that video of satyam scam while stock price falling , 5 points went up in between n held the price for sometimes !! n chart made a pattern too !! who were they buying ? what was their trading psychology….( is it investors/traders who were trying to average ) can u pls reply it gives some ideas…

  12. RAJANNA NAGAMANI says:

    Recently I joined ZERODHA , I am not understanding Which Indicators to be added for DAy Trading

  13. sir, YOU and whole ZERODHA team is doing a great job ….which is priceless…. you are spending lot of time to educate others that also for free, and also replying to all the queries just amazing….. Zerodha is like ‘BJP’ , where Nithin is’Modi’ and you are ‘Arun Jaitley’……..
    im just 20 years of age and i have learnt so much from you about the market…. My Belief in Trading is that “control yourself, because you cant control the market”…. You are the best Teacher i have ever seen…. Thank You so much sir……..

  14. Santosh Shetti says:

    Hi Karthik,
    Just a query, as there is way to calculate Expected Return (for Portfolio), is there way to calculate “Affordable/Bearable Loss” (depending on the Stop Loss we intend to place for each stock) on the overall portfolio?
    What would be change in Expected Return figure arrived at beginning, if say I have made exit after booking loss on some of the stocks in my portfolio?

    Thanks & Regards
    Santosh S

  15. sir, is it possible to backtest supertrend crossover…. if yes what is the code..? im failing to write the code… i tried ….

  16. madhu says:

    shouldn’t it be systemic and non-systemic risk instead of systematic and non-systematic?

  17. S Chatterjee says:

    In the risk versus number-of-stocks graph, what is the numerical / mathematical definition of risk? I think for completeness, the definition of risk should be discussed.

    • Karthik Rangappa says:

      Risk, measured in terms of standard deviation represents the average deviation of the stock returns. We has discussed this in detail over the subsequent chapters.

  18. hari says:

    CARTHICK [email protected]
    Bro plz dont be lazy & complete the last Part I mean Trading Strategies and System & plzz add PDF for Trading Psychology and Risk Management.

    You are doing great job .

  19. suraj says:

    There is no download link for Module 5 & 9. Please provide it to download PDF file.

  20. Mohsin says:

    Dear Karthik, Amazing stuff…. I have read many books written by well known international authors on fundamental and technical analysis, but the way you have explained the trading concepts in your modules with case studies and very simple examples are truly amazing.

    Thank you so much for the great work and dedication to help others understand and excel. It is very hard to find people like you in todays world !!!

  21. Girish says:

    Such a great content…….You explain every thing with an example , in a very simple language…..kudos to you……can you write on financial modeling also….I think that can really help us to understand the actual decision on which professional investors invest….thanks

  22. Amresh says:

    First of all, let me thank you for the wonderful service and education you guys are providing to your customer. Here, I have a small suggestion, if you can put all the varsity content in kindle format that would be really helpful.

  23. Anoop says:

    I have this doubt:

    Suppose everyone heard about the news and started selling stocks of Satyam.
    They who will buy it?

    Won’t be there a stage where no buyers and only sellers?

  24. Ankit says:

    U say 21 stock is ideal portfolio , why is this number considered to be apt ??

  25. ravindra nath says:

    sir iam unemployee i did itraday in commodity. i got loss Rs 8000.i did no di any itr till now do i do or not necessary. will i get any scrutiny from it dept ?

  26. Hiran says:

    One question about diversification as explained by you and also by some expert that 15 –20 stock is best for portfolio.i have questions after reading this unsystematic risk as if we increase no of investment in more company more than 20 then if case happen like satyam then we can minimize our loss.

    Is it correct?

    Thanks
    Hiran

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