Investing: The mirror says it all

While making an investment decision, apart from returns, there is one very important factor that weighs heavy on investors' minds: risk.

Simply defined, it is the uncertainty of happening/non-happening of a certain event(s) that is likely to affect future returns.

A risk is generally attributed to external factors that create disturbance in the existing scheme of things. Some of these external factors are geo-political uncertainties (elections, terrorist attacks and wars), financial crisis and economic downturn.

However, what stock buyers generally fail to understand is that, apart from these external factors, there is one very big 'risk-factor' that is very inherent (or internal) to them. This internal risk is that of 'indiscipline'.

By indiscipline, we mean that stock buyers tend to forget the basic scruples of safe and sound investing, as they are then lured by the high probability of earning 'a big bang for their buck'. These times when everything around seems promising and that the stock markets are rising incessantly (as happened in the most of 2003), discipline generally gives way to chaos.

And this leads to even the best of investors putting their money into the worst of stocks believing that their invested company is the 'next big thing'. Ironically, as just these very times when stock buyers need to stick to the fundamentals of sound investing, they seem to forget these (the fundamentals).

This is where the 'behavioral' aspect of investing gains importance. And this is the time when a stockbuyer, before making the next investment (say investment 'X') should look into a mirror, and ask certain strict questions to himself. First, he needs to ask whether he understands his investment 'X' as well as he thinks he does. This would include:

• Asking whether the investor has enough experience of similar kind in the past. This is like, when an investor is thinking of investing in say, Tisco, he should ascertain what has been his previous experience with the company;
• Asking what has been other people's track record in the past in making a similar kind of investment;
• Ascertaining how much returns should his investment 'X' generate for him to break-even

  after his taxes and cost of making the investment. This would make clear the price that he would be ready to pay for the value of the investment 'X'.

Secondly, the stockbuyer needs to ask himself as to what would be his reaction in case his 'correct' analysis about investment 'X' goes wrong. This would then involve:

• Asking whether he has adequately allocated his assets (into equity, debt, insurance) to tide over losses from his investment 'X';
• Asking whether he has a track record of controlled behaviour (i.e. acknowledging that he made a mistake) or else he would be a part of the overall chaos when things go wrong;
• Asking whether he is relying on a well-calculated approach and what is his tolerance level of risk. He could find out his tolerance level by studying his past losses.

Now, while the answer to the first question (i.e. whether the stockbuyer understands his investment 'X' as well as he thinks he does) would be indicative of the 'confidence' level of the stockbuyer, the answer to the second (i.e. what would be his reaction in case his 'correct' analysis about investment 'X' goes wrong) would speak about the 'consequences' in times his investment decision goes wrong.

If the stock buyer has clear answers for all the abovementioned questions, he would only make his larger task (of making investment 'X') easier. Thus, before you (as an investor with a long-term horizon of 2 to 3 years) invest, make sure that you have pragmatically ascertained your probability of being right and as to how would you react to the consequences of being wrong.

Always, look at the downside before the upside. And always, look into the mirror before investing!

Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.