All investments are a risk-return trade-off. In the search for higher return you have to take on higher risk. But then, higher risk does not automatically mean higher returns. You, therefore, have to be choosy about the nature of risks that you take on.

We all understand the concept of returns. It is normally defined as the extent to which the stock or asset moves in our favor. That means how much it moves up when we are long on the stock and how much it moves down when we are short on the stock. However, risk is a slightly more complex subject. The most common definition of risk is judged by volatility of returns. Therefore a stock that is consistent in performance is less risky than a stock that tends to be erratic in performance. We normally measure the volatility by the standard deviation of returns or the variance of returns. Greater the standard deviation, the more risky the stock is considered to be.

There is a more intuitive way of defining risk and that is defining risk in terms of probabilities or likelihood. From that standpoint, risk is the probability of a bad thing happening or a good thing not happening. Therefore if the profit of the company falls by 20% for the quarter then it is a risk factor for the stock and hence it is likely to be negative for the stock price. Similarly, if the expectation is that the profits of the company will grow by 20% and the actual profit only grows by 10% then that also represents a risk for the stock. That will also have a negative price impact.

What is predictable versus what is not predictable?

That brings us to the basic issue of what should investor focus on? Should they focus on returns that they can earn or the risk that they are willing to take? We can answer this question by examining which of the factors is predictable. Can you really predict what will be the returns on Reliance Industries if you buy at this price? The answer is a clear NO. In fact, most of you would not have imagined that Reliance would have given 80% returns in 1 year especially considering that the stock went nowhere in the previous 9 years. Similarly, it would have been hard to imagine that a star performer like Lupin would lose over 70% of its value in 2 years. Since it is not practicable to take a view on stock prices, what you can predict is the risk that you should take on. Therefore a focus on risk over return really pays off…

What is actionable versus what is not actionable?

This is the second important question that you need to ask yourself. What is it that you can really act upon? Whether Tata Steel will be at a level of Rs.1000 or Rs.500 at the end of 1 year can never be known. When something cannot be known it is hard to initiate any action on the same. On the other hand, you know that your exposure to steel should be only 10% of your equity portfolio. If you are currently at 15% then it does not matter whether Tata Steel will go up or go down at the end of one year. For you, the risk of holding Tata Steel is too high as it is skewing the sectoral mix of your portfolio. Once you are convinced about the potential of a stock and you have bought it, you have little control over how it performs. What you have control over is what you do with your exposure to the stock. In this case, risk can be managed and therefore it is actionable. That is why the focus on risk is a lot more important than the focus on returns when it comes to equities.

Risk also helps draw contours of your returns…

This is perhaps the most important reason why risk is a lot more important than your returns when it come to equities. Let us understand this concept with an example. Assume that you bought Tata Motors and the stock went up by 25% in 3 months. What should you do now? That is where risk comes in and determines the contours of your returns. Whether it means shifting to rolling stop losses or hedging your position with options or converting your position into an arbitrage-lock with short futures; these are all risk management measures that can be used to define the contours of your returns. When you bring in the concept of risk, then you forsake some of your returns. The logic is that a bird in the hand is worth two in the bush. That is what risk defining returns is all about.

If you take care of the risk, the returns will take care. That is the message.