The risk perception

Ever had your friend exclaim at your investment choices with phrases such as ``That sounds like a very risky bet`` or ``That`s a very risky stock``? How about asking the friend to rank your investment risk on a scale of 1 to 10. The friend stares back blankly, implying either you have lost your marbles or they`re lost in translation. So what do you perceive as the risk in your investments?

Fundamental risks
Risk in its varying degrees of perception is the magnitude of fear at the thought of losing something. It could be the fear of losing your home, friend, mobile phone, or money. When it comes to investing, the idea of the risks intrinsic in the business, its operations and environment are also known as ``fundamental risks``.

To borrow the idea of investor Warren Buffett`s `fundamental` risk of investing in a business, there are five primary factors in appraising this risk: The first would be on how confident you are in your judgment of the long-term economics of the business you want to invest in. Take, for example, the much-maligned telecom sector, which has been in the news for deteriorating economics and expensive expansion.

Investing in this sector would entail having a perspective on how consumer behavior is likely to evolve over the next five years and whether consumers are likely to spend more on value-added services or more time on the phone. Add to this, the large number of players in several circles, which means little pricing power.

These are just a couple of factors in the economics of the business on which one needs an informed perspective. A rapidly changing business is often a risky one for an investor who is not watching it closely.

Human elementThe second and third factors deal with the ability of people to run their businesses effectively and their propensity to reward the shareholder and themselves in a proportionate and acceptable manner. Retail investors have traditionally had little say or sources on management. However, gauging how effectively the company communicates to its shareholders through interviews, press releases and annual reports can give you a cursive idea of the management behind a stock. A crooked manager or misinformed, yet ambitious, CEO is a major risk to an investor, considering how he can derail an otherwise good business. An instance of such behavior includes the Satyam episode that saw the slipshod Maytas merger attempt as a prologue to the expose of Ramalinga Raju`s number fudging.

The fourth factor is the effect of external factors such as inflation and taxes on a business. Companies in sectors such as alcohol or tobacco have the constant risk of taxes being hiked at various levels, considering how the products they produce are viewed as ``vices``.

Inflation ravages business with little pricing power or scope for passing on costs. Cyclical industries such as automobiles and consumer durables have often been squeezed by rising costs during periods of low consumer demand, as prices cannot be hiked.

Businesses which are easy scapegoats for government taxation or companies that can be squeezed by the economic cycle are inherent fundamental risks. Sugar companies are a classic example of a sector which gets pushed to extreme highs or lows depending on season, crop yield and a host of other factors. Scale is a savior in such a scenario as small mills become unviable and often go broke during the cyclical lows.

Price
The fifth factor is possibly the simplest - the price you pay. Paying a sensible price can help the investor avoid a great deal of pain associated with moody equity markets. Several retail and professional investors got suckered into buying newly-fangled, esoterically-named, mutual fund schemes or over-priced IPOs during the market peak of late 2008 only to lose their shirts over the next year.

Overpaying is possibly the most common risk the investor overlooks. As Buffett says, the above factors are difficult to `precisely quantify` but ``investors in an inexact but useful way `see` the risks inherent in certain investments without reference to complex equations or price histories.``

The perception of various factors which are deemed `risky` does not always lend itself to a convenient number. But acknowledging that they exist and attempting to base the price you pay after roughly factoring in those risks goes a long way in determining your investment outcome.