Understanding the stock market - Risk Reward | Stocks and Commodities

P R Sundar, Aditya Trading Solutions

September 21, 2013
Time: 9.30 am

Understanding the stock market - Risk Reward:

1. Whenever I meet people, they ask me to suggest some shares that will appreciate by 400% or 500% in one year. 
2. But what they do not understand is that when your expectation about the reward is so high, corresponding risk will also be very high.
3. A stable investment can not appreciate by 400 to 500% per annum.
4. You can get 10000% return in one day. That is possible.
5. All you have to to buy a revolver with Rs 10,000 and got o a bank and rob the bank. You get Rs 1000 crore in one day for your investment of Rs 10000. What is the return? So huge. But what is the corresponding risk? If you fail, you end up in jail for life.
6. So this is called risk reward in stock market.
7. Here I explain, the investments in various sections of the stock market according to their risk leve from highest risk to the lowest risk.

• Penny Stocks - Risk level 1 (Very high risk)                                                                                        Penny stock has the highest risk and reward also will be very high. Some stock are available at Rs1 and if it becomes Rs 2 you get 100% return. But it can also become 50 paise. So you have some surplus cash to invest and you don't mind losing the entire money, you can invest in penny stocks.
• Small cap stocks - Risk level 2                                                                                                           Small cap stocks are second highest risky stocks. These stocks can fall or rise too fast. Usually in a bull market, these stocks tend to do very well. In a bear market, they will under perform the benchmark indices.
• Mid Cap Stocks - Risk level 3                                                                                                            Mid cap stocks are next in line. Slightly better than small cap stocks. These stock also will do well in bull market. Some mid cap stocks will do so well so it becomes a large cap stock one day.
• Large Cap Stocks: Risk level 4                                                                                                           A small cap can become a mid cap and a mid cap can become a large cap but a large cap will be large cap forever. Large caps will be able to withstand the economic cycles due to their shear size of operation. Their borrowing cost will lower compared to mid cap and small cap companies. Therefore the rise or fall will be moderate in large cap stocks.
• High Beta and Low Beta Stocks:                                                                                                        Within the same group of small, mid and large cap stocks, stocks can be classified into two groups. High Beta stocks and low beta stocks. High beta stocks will rise or fall more than the Nifty rise or fall. Low beta stocks will rise or fall less than the Nifty rise or fall. Banking, financial companies, auto companies, real estate companies, commodity companies like steel, cement companies are high beta stocks. High beta stocks are high risk high reward stocks. FMCG, IT and Pharma companies are low beta stocks. They will rise or fall slowly compared to other stocks. Low beta stock are also known as defensive stocks. In a bull market high beta stocks will do well and in a bear market low beta stocks will do very well. For example, GMR Infra which was trading at Rs 200 plus in 2008, trading now below Rs 20, lost more than 90%. But stocks like Lupin, Sunpharma have more than doubled from 2008 level, because we are in a long term bear market.
• Nifty                                                                                                                                                  What is Nifty? Nifty is the weighted average price of top 50 stocks of India. So if you buy Nifty (actually you can not buy Nifty as it is only a number, you can buy Nifty bees that is one tenth of Nifty) you are actually buying all the 50 stocks. All the 50 stocks will not rise or fall in a same day and the magnitude of rise or fall will not be same for all 50 stocks. So on an average the Nifty will not rise or fall so much. So your reward may be less but your risk will also be very less.
• So risk averse investors may consider buying Nifty bees instead of shares. 

The stock market is all about risk reward. The higher the risk the higher the reward. Lower the risk lower the reward. 
In my next article, I will explain some more ways of investing with lower risk than the Nifty bees.