It’s been a few months since you started investing—despite careful research and stock selection, why isn’t your investment performing well? Investing in the stock market seems exciting, but it comes with uncertainty. Even a single piece of news related to corporate events or business policy changes can put your holdings’ value on a price chart in red. To deal with this scenario, it becomes crucial to learn about the key strategies related to risk management in stocks. Let’s discuss this in detail.
Types of Risk in the Stock Market
Before discussing risk management in stocks, it is crucial to understand the common risks you may face in the market. Here are some:
Market Risk
Market risk occurs when stock prices decline due to economic downturns, geopolitical events, or financial crises. Even fundamentally strong stocks can lose value when investor sentiment turns negative.
Liquidity Risk
If a stock has low trading volume, you may struggle to sell it at a fair price. Sudden sell-offs in illiquid stocks can lead to sharp price drops, impacting investment returns.
Credit Risk
When you invest in corporate bonds or debt securities, credit risk arises if the issuing company defaults on interest payments or principal repayment. The issuer’s poor financial health increases this risk.
Interest Rate Risk
If interest rates rise, the value of fixed-income investments like bonds declines. You may also see stock prices fall because higher interest rates raise borrowing costs for companies, reducing profitability.
Company-specific Risk
A stock can decline due to poor management decisions, fraud, declining sales, or operational failures. Even if the overall market performs well, bad news about a company can lead to sharp price drops.
Key Strategies for Risk Management in Stocks
You can manage the risk associated with your stock investment portfolio to some extent by implementing the following strategies.
Diversification
Diversification means spreading your investments across different asset classes, sectors, or stocks within the same industry. For example, suppose your portfolio focuses solely on the automobile sector. The government recently announced a temporary ban on diesel cars. In this case, manufacturers will find clearing their diesel-engine car stocks difficult. This would ultimately result in a downturn in the automobile sector that may lead to significant losses in your portfolio. However, the losses would be minimal if you followed a diversification strategy to minimise investment risks by spreading your capital across the IT, banking, and FMCG sectors.
Stop-loss Orders
A stop-loss order limits potential losses by automatically selling a stock when its price falls to a predetermined level. Thus, it protects your capital from further declines beyond your risk tolerance.
The ideal stop-loss level depends on market conditions and strategy; technically, it should be placed below key support levels. For example, if you buy a stock at ₹1,000, expecting an uptrend, you would set a stop-loss at ₹950 (5% below). If the price drops to ₹950, your trade automatically exits, preventing further loss. However, remember to adjust the stop-loss limit to align with market conditions continuously.
Rupee-cost Averaging
Rupee-cost averaging is a risk management strategy in stocks where you invest a set amount at regular intervals, irrespective of market conditions. This tactic helps minimise the impact of market volatility, as you acquire more units when prices are falling and fewer when prices are high, reducing the average cost per unit over time.
For example, if you put ₹5,000 monthly in a mutual fund, you may buy 50 units at ₹100 in one month and 55 units at ₹90 the next, effectively averaging your purchase price.
Hedging
Hedging is another noted strategy for risk management in stocks. It involves taking an offsetting position on the stocks in your portfolio. Common methods include using derivatives like futures, options, and swaps.
Suppose you own 100 shares of XYZ Ltd., currently trading at ₹500 per share. You fear the stock price might drop in the next month. To hedge your risk, you buy a put option with a strike price of ₹480 for a premium of ₹10 per share.
Before we dive into the calculation, let us explain put options to help you understand this stock market risk tip.
A put option gives you, the holder, the right, but not the obligation, to sell a specified amount of an underlying asset at a predetermined price within a set timeframe. Now, back to the example.
Scenario 1: Stock Price Falls to ₹450
- Your stock value decreases: 100 × ₹450 = ₹45,000 (Loss of ₹5,000)
- Your put option gains value: (₹480 – ₹450) × 100 = ₹3,000
- Net loss after the premium: ₹5,000 – ₹3,000 – ₹1,000 = ₹3,000
Scenario 2: Stock Price Rises to ₹520
- Your stock value increases: 100 × ₹520 = ₹52,000 (Profit of ₹2,000)
- The put option expires worthless (-₹1,000 premium paid)
- Net profit: ₹2,000 – ₹1,000 = ₹1,000
Hedging limits the loss while increasing the likelihood of gains.
Consider Non-Cyclical Companies
Non-cyclical companies refer to those operating in industries that have zero or minimal impact from economic downturns. For example, during the onset of COVID-19 and global lockdowns, when many businesses experienced steep declines in sales and revenue, the pharmaceutical sector provided traders and investors with decent gains.
Similarly, in a recession in India, people would still be buying essential items like toothpaste, flour, soaps, etc. In this scenario, if you consider this risk management strategy and include a significant proportion of FMCG stocks in your portfolio, you won’t have to worry about losses.
Consider 3-5-7 Rule
If you are a greedy trader, you might not like this risk management strategy. According to this rule, you should place a stop loss at 3% of the price at which you purchased the stock. If the share falls by 3%, make an immediate exit.
The 5% here signifies partial profit booking. For example, if you have purchased a share at ₹1,000 and the stock price surged to ₹1,050, you should sell some of your holdings to secure a profit that can offset the loss if the market dips in the coming sessions or the same session.
The 7% points to a full exit, which means if the price reaches a 7% gain, exit the trade to secure profits.
Research Fundamentals
While not exactly a strategy for risk management in stock, it forms the foundation that every investor and trader must consider to minimise losses: focus on fundamentally strong companies.
Start by reviewing the business’s income statement and analysing quarter-on-quarter revenue and profit growth. If they are steady, take it as a positive sign. If the revenue is positive but there is a dip in profit in one or two quarters, and the reason behind it is the payoff of major debt, you can consider it a positive sign.
To understand the company’s potential, also consider its free cash flow, promoters’ holdings, and recent purchases from FIIs or mutual fund houses.
Conclusion
While investing in the stock market offers many growth opportunities, it is important to approach it with a disciplined risk management strategy. By diversifying your portfolio, using stop loss, considering rupee cost averaging, and other ideas discussed here, you can reduce risks and boost your chances of long-term financial success.
