How to Manage Risk When Investing in the Stock Market (Value Investing FM) – Investment Academy – Learn value investing from scratch

How to Manage Risk When Investing in the Stock Market

Risk managementIt is an essential factor to take into account when investing in the stock market.However, also one of the worst interpreted factors. In this program we explain what risk is (and what it is not), we will analyze whether it can be measured and we will focus on different methods to control the risk of our investment portfolio.

Tabla de contenido

  • Seth Klarman defines risk as “the probability of permanent capital loss " that we face when investing in an asset. There are other definitions, but this one is quite useful. The downside is that it does not include the opportunity cost. Being 10 years with a return of 0% nominal is also a great risk.

    Risk has 2 components:

    • The intrinsic risk of the asset
    • Investment risk

    El intrinsic risk of the asset it will depend on what happens to the company in which we have invested.

    Example:

    • Your product goes out of style
    • Your suppliers raise prices
    • New competitors enter
    • They nationalize their assets

    El investment risk It will depend on the price we pay.

    Any investment can be good or bad depending on the price (unless it is worth zero).

    At a lower price, less risk, for the same asset.

    EYE! It has nothing to do with the price. A company that trades at € 2 per share is no less risky than one that trades at € 200

    Can you measure the risk of an investment?

    The financial world is obsessed with measuring risk, as it is key when making investment decisions.

    However, it is impossible to measure it accurately, as it depends on many factors that are beyond our control:

    • Regulation
    • Management team decisions
    • Competitors' decisions
    • Changes in consumer behavior

    In addition, we cannot know the risk assumed ex post, that is, after the trigger that caused the risk.

    In the same way, that something went well does not imply that it was without risk.

    For example, betting all your money on roulette and that it turned out well, does not mean that the decision is not stupid.

    The invested return-risk binomial

    El classic model of the profitability-risk binomial states that the potential return increases as the risk in an investment increases.

    Using this principle, individuals associate low levels of risk with low potential returns and high levels of risk with high potential returns. According to this model, the money invested can generate higher profits only if the investor accepts a greater possibility of losses..

    It is true that it is common for profitability and risk to be directly related in most investments. Assets with higher risk tend to offer higher returns and vice versa. However, that does not always happen. As we will see, there are times when the relationship between profitability and risk is reversed, in many cases becoming great investment opportunities.

    The Price and the Inverted Return-Risk Binomial

    To understand this investment in the direct relationship between profitability and risk, it is necessary to understand the relationship of each of these factors with the price we pay for an asset.

    On the one hand, when we decide to buy an asset, there is a risk of paying for it a price higher than the value it can generate in the long term. Thus, the lower the price we pay for the same asset, the lower the risk of paying too much for it.

    Furthermore, profitability is also related to the price we pay for an asset. So, the lower the price we pay for the same asset, the higher its potential profitability.

    As we can see, both the relationship of profitability and risk with the price paid for an asset is inverse. Therefore, if we pay a lower price for an asset, the profitability will be higher, but your risk will be lower. As we can see, the relationship between profitability and risk is not direct, but quite the opposite. In other words, the profitability-risk binomial is reversed that should occur in theory.

    Example applied to stock investment

    The best way to understand this is through an example.

    Imagine that you buy a share for € 10 which, according to your calculations, is worth € 20. In this case:

    •         It has 100% potential.
    •         The risk is that it is worth less than € 10

    Now imagine that the stock price has fallen 50%. If you buy that same share for € 5, as long as your intrinsic value has not changed, the following would happen:

    •         It has 300% potential.
    •         The risk is that it is worth less than € 5

    As you can see, the same asset can have a lower risk and a much higher profitability potential just because of a change of mood in Mister Market.

    In my opinion, internalize the concept of the invested return-risk binomial is one of the keys to be successful in investing in the stock market, as it will help us view declines as investment opportunities that not only increase our potential profitability, but also reduce the risk of our portfolio.

    I would like to end this article with a phrase from Warren Buffett in which it perfectly explains the inverse relationship between potential profitability and risk in value investing:

    Sometimes risk and reward are positively correlated. If you buy a dollar bill for 60 cents, it is more risky than if you buy a dollar bill for 40 cents, but the expected reward is greater in the second case. The higher the reward potential in a value portfolio, the lower the risk.

    How to protect yourself against risk?

    The margin of safety

    We can define the margin of safety as the difference between the price of an asset and its intrinsic value.

    Therefore, the lower the price of a financial asset, the higher its margin of safety, as long as its intrinsic value does not vary.

    The margin of safety protects us from various factors:

    • Unexpected events within the company
    • Changes in the industrial sector
    • Economic crisis
    • Analysis and evaluation errors that we make about the company

    In addition, the higher the margin of safety, the higher the potential profitability.

    The circle of competence

    We can define the circle of competition as set of companies or sectors that an investor can and wants to know and understand in depth.

    Must rule out two types of companies from our circle of competence:

    • Which are too complicated to understand. (Ej. Banca)
    • Which we are not interested.

    The circle of competence is:

    • Subjective: It depends on each person
    • Variable: Usually increases over time. That must be our goal.

    Investing in companies within our circle of competencies gives us 3 benefits:

    • Lower risk
    • Higher profitability
    • Greater efficiency

    Diversification

    La diversification consiste en la investment of our assets in different assets whose profitability is not correlated.

    Advantages of diversification

    Diversification avoid risk concentration.

    • Ease
    • Effectiveness

    Disadvantages of diversification

    Diversification means stopping investing in our best ideas to invest in not-so-good ideas, which can harm our profitability.

    Furthermore, diversification has a coste of time.

    On how to diversify, you have it explained in the free Investment Academy course, since we do not want to extend too much in this part.

    How much to diversify

    My recomendation:

    • Beginners: From 20 to 25 companies
    • Intermediates: From 15 to 20 companies
    • Advanced: From 10 to 15 companies

    This should be taken as an orientation.

    • You should never diversify to diversify.
    • Invest only in companies that you have analyzed and have potential.

    Final recommendations on risk management when investing in the stock market

    Do not copy blind

    • You don't know what to do when a stock falls

    Training

    • Free course on stock investment
    • Advanced value investing training
    • Lots of very good books, talks, etc.

    Do not buy mines or raw materials or boats