How to weigh the risk of equity investments?

How to weigh the risk of stocks, mutual funds and IPOs?

Investors allocate their investible surplus into various assets to diversify risks and achieve holistic portfolio growth. There are several asset classes, and we have discussed six major asset classes earlier. Amongst these, the most popular moderate to high-risk, long-term investment option is ‘Equities’. An investment into equities can be either direct, through mutual funds or via IPOs. While equity is a risky asset class, each sub-segment has nuances and different risk levels. Further, mutual fund investment happens across several asset classes, and equities will be one portion. Herein, we will briefly discuss these investment types and elucidate how to weigh the risk of equity investments, like, stocks, mutual funds, and IPOs.

Understanding stocks, mutual funds and IPOs

Stock is equal to investing in a company and becoming a part-owner. The rights of ownership like voting power, right to transfer ownership, dividends, bonus, split, etc., come with the purchase of shares of a company.

In the case of mutual funds, a set of professionals called asset managers manage the pool of money. The investors subscribe to a mutual fund and contribute money. The fund managers invest in shares, bonds, commodities, etc., as per the mutual fund’s objective. The money gets invested into a large base of stocks that fulfil the fund’s investment objective.

In an Initial Public Offer (IPO), private companies offer their shares to the public. Often, IPOs are an exit route for existing shareholders allowing them to unlock the initial investment, often at a premium. At the time of an IPO, there can be (1) a fresh issue of equity shares, (2) an offer of existing shares (aka Offer For Sale) by the current shareholders, or (3) a combination of both.

Associated risks with equity investments

Equity investments carry risks, and there is no quarrel about this at all. In other words, some risks exist, irrespective of whether invested directly or through mutual funds or IPOs. The degree differs.

A few risks exist for every equity investment, both internal and external. Therefore, an investor must understand and know them entirely well.

First, equities are subject to market risks. Even if not directly linked to the company under consideration, several factors can impact equity share value. Above all, many times, investors may not even be able to comprehend these factors. These could be political, economic or other global risks.

Second, there are company-specific risks that every company faces. Like, credit risk where the company cannot pay its debt. Liquidity risk is when the company cannot meet its short term obligations.

Lastly, there is concentration risk. In this case, the company’s operations are limited to a single sector; one or just a handful of customers contribute to a large portion of revenue, or the company operates primarily in one geography. As a result, any issue in that sector, loss of contract from that major customer or unrest in the area of operation can disproportionately impact the company.

Let us delve into specific considerations for each investment category.

Direct equity investment

Stock markets, in general, have delivered handsome returns to investors. Recently, BSE Sensex mounted to 60,000 points, and NIFTY came an inch closer to 18,000 levels.

Many stocks touched or even crossed their lifetime highs. However, like any other investment with the potential to gain money, there is a chance to lose. So when you invest in a particular stock, the risk is exceptionally high. And that is very similar to the concentration risk. However, an investor can diversify investment into several equities, thereby reducing the concentration risk. But, of course, this action comes with a significant increase in capital invested.

The second essential aspect to note is systemic risk. A possibility that an event could trigger a collapse of an entire industry or economy. Some companies are too big to fail, and investors must remain aware of such risk even if they have not invested in that big fish.

The third critical point to know is the company’s free float. The measure of the actual number of shares available for trading and public investment is called the free float. The higher the free float, the easier it is to trade in shares. The number of shares readily available in the market determine the liquidity risk. Usually, for day to day investing, liquidity is not a problem. However, this is another factor to know before picking up stock.

Finally, the cash flows generated from an equity investment must be higher than the loss of purchasing power of money due to inflation. The risk of losing value is called the inflation risk. In other words, the total gains from cash inflows from equity investment, including the capital appreciation, must be higher than the cumulative inflation impact during the holding period.

Mutual Funds

An investment in a mutual fund achieves diversification. That is one of the most significant advantages, any money invested gets split into several asset classes. The amount of money invested into equities, for instance, is further divided into many shares.

However, one critical risk is when an investor picks schemes (from different fund houses) with similar objectives. Although the investor may seem to have divided funds, these schemes would invest in the same or similar set of stocks. The investor may not achieve the purpose of diversification in this case.

Secondly, sectoral concentration is still a risk while investing in mutual funds. For instance, you invest in the Nifty50 index fund and Banking & Financial services sectoral fund. As you can imagine, banking and financial services companies are a part of the index as well. Currently, in the large-cap space, about 30% of the index is banking stocks. So an investment in these two funds creates an obvious overlap. Therefore, investors must choose funds that have negligible overlap to reap the full benefits of diversification.

Thirdly the bond rates can affect the performance of debt mutual funds. Rising interest rates will lead to lower debt fund prices, and therefore, loss of value. Understanding the external environment, primarily the interest rate scenario will be advantageous to mitigate this risk.

Lastly, the flexibility to choose the time, entry or exit price, and even the share to invest into does not exist in a mutual fund. Instead, the fund manager takes all the decisions. In other words, it is inherently critical to study the fund manager’s past performance to be confident of the money invested via a mutual fund.

Initial Public Offer (IPOs)

Equities are inherently risky, and IPOs are even more. An investor’s risk appetite decides the investment strategy. Unfortunately, limited information about the new company and inadequate disclosures limit a thorough evaluation of the performance of the IPO company.

Therefore, retail investors with low-risk tolerance should ideally stay away from IPOs unless there is a compelling proposition. Invest must methodically assess if they should invest in an IPO. If yes, they must always only apply for fundamentally strong companies.

There are certain inherent risks that IPO carry, those are:

  1. The quality of financial reporting is not up to the mark
  2. IPOs are an exit route for initial investors and often highly-priced
  3. There is limited information to gauge financial strength and to understand the operating cadence
  4. Significant emphasis on peer evaluation, which may not always right the correct inference
  5. Too much reliance on promoter pedigree and anchor investors background

Above all, given the recent retail participation, getting shares allotted is also considerable risk. Read more about retail allocation methodology here.

The bottom line – which one is the riskiest?

Each asset has its DNA. There are risks, and there are returns. And then, there are high risks and high returns, and vice versa.

In other words, the choice of quantum of risk to partake is always investors prerogative. Investors should deeply assess their ability to take a chance and determine their risk tolerance.

Every investor is different, and so is the risk appetite. As a result, there is no one answer or one investment strategy that suits all. Similarly, no one asset allocation policy fits all.

Among the three investment opportunities discussed here, mutual funds are the safest, followed by direct investment into stocks. In other words, IPOs are arguably the riskiest. However, that does not mean that a fundamentally strong IPO is risky. On the contrary, that could be safer than the other two. But, only an in-depth assessment will provide the answer.

In conclusion, the existence of risk is central to all investments, especially in stock markets. A calculated risk can yield better returns, and investors must always make informed decisions.

Happy investing!

About the author

The author is a senior finance professional with over fifteen years of work experience in corporate finance. He has an affinity for matters relating to personal finance and investment management. Through his writing, the author wants to share his knowledge and understanding of the subject.

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The author has used his knowledge, experience, and understanding of the subject and has exercised extreme caution to avoid possible mistakes. However, the author does not take any responsibility for any error that exists.

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