What Is Risk?
Warren Buffett, widely regarded as one of the world’s greatest investors, has famously asserted, “Risk comes from not knowing what you’re doing”. He’s correct, of course, but who admits that? “Risk management” in this context refers to the process of identifying, evaluating, and addressing the potential dangers posed by stock market investments. Due to inherent uncertainty and volatility, investing in stocks necessitates vigilant risk management. As a result of the unpredictability of stock prices, all investments carry the risk of loss.
The trouble with a lot of investors is that that are lured to an investment overwhelmingly by the potential gain. Of course, this is a natural reaction and on the face of it just fine. Who doesn’t want to make a quick buck? The challenge arises from the conflicting priorities of pursuing profit and the necessity to assess risk beforehand. Investors essentially are blinded by the potential riches and forget that starting with the risk in the investment is paramount to the potential return. As an investor, it’s always prudent to start with risk. Establish what you can lose and measure the return secondary. It’s important to recognize why this is usually not the case for most people.
- The Potential For Higher Returns: Frequently, investors are prepared to accept greater risk in pursuit of higher returns. The stock market has historically outperformed other asset classes over the long term, but it is also more volatile. Long-term returns may be higher for investors willing to assume increased risk.
- Behavioral Biases: We discuss this elsewhere, but it could be one of the strongest reasons for forgetting to evaluate the risk. Investors often overestimate their predictive abilities, leading them to make risky investments without a full understanding of the associated risks. Confirmation bias (selectively interpreting information that aligns with their existing beliefs,) social influence and fear of missing out (FOMO) are some of the more common ones that place highly in the brain.
- Lack of Knowledge And Experience: Some investors may lack the knowledge and experience necessary to comprehend the risks associated with investments. This may cause them to make risky investments without a complete understanding of the hazards involved.
- Focus On The Short Term: Certain investors may prioritize short-term gains over long-term objectives, compelling them to engage in riskier investment decisions in pursuit of immediate profits.
When I look at an investment, I clearly start with how much I can lose. Or at least I try to estimate how much I can lose. Unforeseen events can alter the path, but they are rarely positive, so it’s good to look down on all the types of risk the company is exposed to. Having a checklist is a good way of making sure you have carried out your due diligence and of course, confidence in your investment.
There are macro and micro risks in every investment. Normally I tend not to go too deep on the macro implications, mainly because I am not that good at it. Further, I have never known anyone who was consistent either. There are just too many moving parts on a high level. The complexity of the economy, government actions, global factors and information limitations are all very good reasons to stary away from macro forecasting.
While investors can make informed assessments of macroeconomic trends, predicting precise economic changes is a daunting task. Rather than endeavoring to predict short-term economic shifts, it is often more prudent for investors to concentrate on their own financial objectives, risk tolerance, and long-term strategies. You can get to those by evaluating the specifics risks.
Market Risk
Arguably this is borderline macro. Again, I have met very few people in my career that can predict the market correctly over a longer period. I often say the market was set up to fool people. Systemic risk, often known as undiversifiable risk, is another name for market risk. It’s the kind of risk that can’t be mitigated by spreading your holdings across several markets. All securities and asset types are vulnerable to systematic risk since the market is at risk.
You are an investor with a diverse portfolio of equities, bonds, and other assets. You’ve carried out your research and diversified your investments to manage risk intelligently. However, bang! An economic catastrophe occurs, such as a flash crash or a financial crisis that you just didn’t see coming.
This is when the excitement and also fear starts. We refer to this as systematic market risk. Suddenly, it resembles a stock market transaction. Almost everything in your portfolio begins to lose value, regardless of how meticulously you assembled it. The value of stocks plummets, the desirability of bonds diminishes, and there are losses all around. Moreover, guess what? This party isn’t just for you; it’s an all-inclusive event that affects every investor and their assets. You cannot avoid it despite your efforts.
Simply put, systematic risk is a type of risk that focuses on the broad picture. It’s things like economic ups and downs, interest rate fluctuations, political insanity, and other large-scale occurrences that disrupt the entire market. So, what is the conclusion? Diversify your investments not only within various types of assets, but also across different types of assets to reduce the impact of events such as these.
Why Market Risk Is Low When It Seems High
Benjamin Graham coined the term “Mr. Market” as a metaphor for the stock market in his book “The Intelligent Investor.” Graham characterizes Mr. Market as a manic-depressive investor who offers to purchase or sell your privately held company’s stock at a different price every day. Mr. Market might be very optimistic about a company’s prospects and offer to buy your shares at a high price. However, if the company’s earnings disappoint, Mr. Market might become very pessimistic and offer to buy your shares at a low price. Graham argued that investors should not be swayed by Mr. Market’s mood swings. Instead, they should focus on the intrinsic value of the company and buy stocks when they are trading below their intrinsic value.
The idea of Mr. Market remains pertinent in the present day. Investors should stay mindful of the stock market’s occasional irrationality and avoid allowing their emotions to obscure their judgment. By placing emphasis on a company’s intrinsic value, investors can make well-informed choices, potentially yielding better long-term returns. Graham’s point is that investors should not let the short-term fluctuations of the stock market dictate their investment decisions. Instead, they should focus on the long-term value of the companies they invest in. I guess if you are a true stock company investor, it makes you a value investor. Value investors believe in the power of mean reversion, a long-term horizon, and a very disciplined approach to investing. With this and the above in mind, market risk can be ignored to a great extent. However, telling your emotional brain that is a different thing altogether.
Company Specific Risk
In summary, company-specific risk is a form of risk that is unique to a particular company and unrelated to market conditions. It can be caused by a variety of variables, such as managerial decisions, operational issues, legal matters, and financial health. Make no mistake, company specific risk is the most important to consider. This is the risk that the company itself will underperform or fail, regardless of what happens to the overall market.
Company-specific risk, often known as “idiosyncratic risk,” is a type of risk that is specific to a given business and not influenced by macroeconomic or industry trends. A firm’s financial results, share price, and overall value might be significantly impacted by events, circumstances, or variables that are exclusive to that company. These factors can include management decisions, corporate governance issues, operational problems, product recalls, lawsuits, and other events or conditions that are specific to that company.
Causes Of Company-Specific Risk
- Poor strategic decisions or mismanagement on the part of the company’s leadership might put the business in jeopardy. The company’s finances could be damaged, for instance, by a poorly implemented expansion strategy or a dubious acquisition.
- Production delays, supply chain disruptions, and quality control problems are all examples of operational challenges that can lead to company-specific risk.
- Concerns with the law and governing bodies lawsuits, regulatory investigations, and noncompliance all pose unique dangers to businesses because of the costs and reputational harm that can follow from them.
- The financial health and creditworthiness of a business can be a source of risk unique to that business. Companies with high levels of debt or cash flow issues may be more susceptible to financial difficulties.
Impact Of Company-Specific Risk
- Risk unique to a company may cause big swings in the price of its shares. Volatility is something to be aware of and can often shake you out of a position. Positive developments can lead to price gains, whilst negative news or occurrences might cause a stock’s value to drop sharply.
- Company-specific risk may have a direct effect on a company’s financial success. For instance, a product recall might affect profitability by lowering sales and raising costs.
- Bondholders and creditors may view company-specific risk as posing a threat to the company’s capacity to pay back its debts. Credit ratings could be downgraded, or interest rates could go up as a result. This is a credit risk and something to consider.
Some major companies in 2022 faced company specific risk. Meta (Facebook): Meta has been facing several company-specific risks, including declining user engagement, regulatory scrutiny, and increased competition from TikTok. As a result, Meta’s stock price fell by more than 50% at the beginning of 2022.
Another darling of the tech world fell over 70% in 2022. Netflix
NFLX
Even the popular meme name Robinhood has been facing several company-specific risks, including regulatory scrutiny, declining trading activity, and customer backlash over its handling of the GameStop trading frenzy. As a result, Robinhood’s stock price fell by more than 80% in 2022.
Mitigation
As company specific risk is the most important thing to consider, I suggest spending 80% of your time analyzing it. There are practical ways you can reduce this risk although some things you can never predict.
There are two camps of portfolio managers. The very focused portfolio manager or the diversified one. Personally, I like to be very focused. I want 12-15 names I know inside out. However, this is a good argument for diversification of the portfolio. You can mitigate company-specific risk by diversifying your portfolio by holding a mix of different stocks and assets and reduce your exposure to the performance of any single company. Sometimes this is not as easy as it may sound. I’ve seen many concentrated portfolios all ‘tech’ or all the majority ‘energy’ related for example. If one company warns about something, you could find your whole portfolio taking a hit. This also borders on sector risk too. Just don’t put all your eggs in one basket.
Liquidity & Currency Risk
There are a few other risks you should consider. One is liquidity risk. I’ve seen too many. One recent example was the GameStop. On Reddit’s WallStreetBets and other social media sites, a group of retail investors orchestrated a major buying campaign in GameStop (GME) and other highly shorted stocks in January 2021. The price of GameStop stock skyrocketed due to the unexpectedly high demand for its stock. This real-world occurrence illustrated the dangers of investing in massively shorted, low-liquidity equities. Unpredictable transaction executions and price volatility can be the result of the fast and dramatic price swings produced by a rise in retail investor interest. It also sparked debates about market oversight and the impact of small investors.
Finally, risk of financial loss or price volatility due to changes in the value of one currency relative to another is known as currency risk, exchange rate risk, or foreign exchange risk. Those who frequently deal in foreign exchange or other financial operations involving various currencies are particularly vulnerable. The following are crucial to understand currency risk and how it might affect various parts of financial activities. It’s important to check your chosen targets exposure to international operations.
In Summary
Successful investors always put risk analysis ahead of profit and loss (P&L) calculations. This strategy stresses the value of taking calculated risks and protecting your initial investment. You may better align your investments with your risk tolerance and make more logical decisions if you do some preliminary risk assessment to determine the possibility and potential impact of bad events.
Putting risk assessment first suggests distributing investing capital across a variety of asset classes and industries to lessen the blow of any single underperformer. The extended view it encourages can assist you avoid making hasty decisions out of greed or fear. Instead, you should aim for a rate of return that is proportional to the amount of risk you are taking to achieve your financial goals and return.
Investing in ways that are consistent with your risk tolerance and financial goals is a crucial part of effective risk management. Achieving long-term success and I want to emphasize the long term requires putting risk considerations ahead of profit and loss projections. Think carefully about this before you execute your next investment. You’ll be part of the 20% that do.
If you are interested in learning more about ideas from my company The Edge, drop me an email at [email protected]
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