Did you ever calculate the risk before making a stock investment?
Don’t know about you but for me, the answer is – Of course, YES.
Any investment without calculating the risk is like putting your money for gambling and praying for quick bucks.
It’s a “must do” thing.
There’s is no stable yardstick to perfectly judge how much risk you may confront by investing in any particular stock or sector.
However, one has to assume the risk by judging the market situations relatively that too on micro and macro level.
For most Investors, however, it is a highly underutilized and misunderstood metrics.
Biggest struggling point:
How to reduce the risk and ultimately increase the chances of returns on our investments?
Short answer:
Risk arises out of arrogance. Define your circle of competence and don’t dare to get out of it.
Long answer:
I regularly get questions from fellow investors on Twitter, emails and from people on Quora that sound a little somethin’ like…
“How do you do it all without getting completely overwhelmed?”
And the answer is: I don’t.
Don’t get me wrong…I used to “do it all.”
Multiple blog posts every week, active participation on different social media, investing forums and most important, digging out tons of stocks.
Which all amounted to nothing more than a little increase in income that was barely worth the overwhelm “Oh shit!” efforts.
But in the past few years, I learned perhaps one of the most important Investing lessons there is…
The best way to stay AHEAD of nerdy crowds is by doing LESS.
Here’s the crux: by focusing on too many different stock/sectors (in which you’re actually assuming a huge growth within) is stunting your wealth by spreading yourself too thin.
So what to do?
Follow Warren Buffett.
……define your circle of competence which ultimately helps you to reduce the risk.
This single image from Farnam Street is enough to understand the concept at a glance.
“I’m no genius. I’m smart in spots-but I stay around those spots.” – Tom Watson Sr., Founder of IBM
You don’t need MORE strategies and “things” to do. You need to focus on what works best.
The key to making it happen? Find the handful of stocks and sectors that interest you the MOST and put all of your effort in this direction.
“Don’t get your leg in the business you don’t understand”
Still not understandable? This story will clear it out.
Back ago, A friend of mine (who was a Civil Engineer) lost a huge amount of wealth in stock market.
He heavily invested in pharma stocks and as this sector is highly volatile, he lost his money on a very decent day.
I asked him a simple question – Why you invested in Pharma stocks despite of the fact that you know nothing about pharmaceutical field?
He revert back – Do I need to understand the field to invest in stock market?
This is where every investor fails. They invest beyond their capacity of understanding aka Circle of Competence.
Another fancy buzzword coined by Warren Buffett – Circle of competence.
The bones of the concept appear in Berkshire Hathaway 1996 Shareholder Letter by Warren Buffett:
What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
The key idea behind the circle of competence is not its size – the number of businesses you can understand – but your awareness about its size – the number of businesses ‘you know’ you can understand.
Img – sharesinv(dot)com
If you want to improve your odds of success in life and business then define the perimeter of your circle of competence, and operate inside.
Here’s how Safal Niveshak describes it:
A business will be ‘within’ your circle of competence if you fully understand the underlying economics of it:
- How it works?
- What drives its growth?
- What makes it profitable?
- How does it stand against its competitors?
- How does it manage its raw material costs?
You need to have the answers to such questions, and others like these to make sure that you understand the business. To invest in something you do not understand can have disastrous consequences.
So how would you stay inside the circle of competence?
Let’s get back to story of my friend.
My friend was a civil engineer and who invested in pharma stocks without understating what the underlying businesses were.
Instead, if he invested in construction stocks like Larsen & toubro, KNR Constructions etc. The result would had much better……..
………. because as a civil engineer he understand this sector. He knows the in and out of the “how contruction company works?” “What are the related risks?” “What drive the profits?” etc.
What’s his circle of competence?
These.
These are the construction stocks.
There are 2 things to look over whenever you invest in the stock:
- Company
- Industries
And my experience says, that the estimation of later is quite hard as compared to former.
My Civil Engineer friend already had an underlying understanding of this sector/field. What more he need to do is just concentrate on the financial statements to figure out whether the company is quite up to the mark in its Industries or not.
He doesn’t need to look at every freakin’ sector. Just concentrate on the sector which he can understand easily.
It’s a win-win-win situation. Save time! Less risk! More returns!
I sometimes get frustrated with the emails I receive from the people on randomly picked stocks. They think that I have the track of every stock or can analyze stocks in a couple of minutes.
……but they are wrong, Frankly speaking, I too have my own circle of competence. I never invest in construction and 2–3 wheel automobile stocks.
Now if anybody asks me about Ashok Leyland or Tata Motors – I’m simply blank.
So what to do? Again the same answer – Find the circle of competence.
Are you a Doctor? Chase Pharma stocks.
Are you a Software Engineer? Chase tech stocks.
Are you an Economist? Chase bank stocks.
Are you a retail manager? Chase consumer goods stock.
There’s something for everyone that will interest them. Just don’t settle for finding it. Even a full-time gamer can chase stocks like Ninja (Pokemon GO).
Don’t get confused. You don’t need a degree to understand the Industries. Even an average person can understand any industries with little efforts. Go on and find the industries that best fits your mind. And remember, stay away from the stock/sectors that you don’t understand.
More you’ll be in your circle, less will be your risk.
Most people think risk calculation has to be an effort worthy endeavor that takes thousands of mind tumbling thoughts followed by hours of unit calculation to see any success with.
This is simply not the case. There’s a simple metric used to calculate the risk factor.
Beta.
To some, it’s merely another fancy buzzword. To others, it’s the backbone of their entire investment philosophy.
When I just entered this field, I was confused with term “beta”. Scholars keep using this term in their analysis and many books talk about this beta risk.
……..after a long time digging into the concept, I understood the perfect meaning and application of the term.
Before I give my explanation, let’s see what Google (Investopedia) says about it:
Beta is just s unit to compare relative risk of the stock or sector.
Let’s take an example: Imagine for a sec, that there are only 3 companies in the market – X, Y, and Z.
X has a risk of 2, Y has 3 and Z – 4.
What’s the average market beta risk?
It’s the average of all above numbers i.e. (2+3+4)/3 = 3.
What would be your analysis from above metrics?
1 is known for base risk rate which normally happens in any conditions. Keeping this fact in find, read the conclusions from these metrics below:
- Currently, the market is trailing around 3 times of normal risk.
- X has 33% less risky as compared to market averages.
- Y has the equal risk as compared to market averages.
- Z has 33% more risky as compared to market averages.
So, here’s the prime conclusion, X is the best investment opportunity currently available in the market. It’s 33% less risky, hence profitable against other stocks.
But the calculation of risk varies from one person to another. The risk is calculated on many estimated factors which can create a great overall error to our results.
More the accuracy in estimation less will be the risk but the statistical error will always be there waiting for you. Nobody can estimate the perfect value of risk in the uncertain world’s climate.
Even Warren Buffett can’t predict the perfect numbers for risk. His strategy is to invest in the companies with less uncertainty in the long run to reduce the statistical error.
However, the negative statistical error is good because it shows that you took margin of safety in your analysis.
Here’s another way to look at the risk factor which I learned from The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit by Aswath Damodaran.
>>> Relative risk <<<
It considers risk in a relative way by comparing 2 or more companies or sectors or element.
For example:
- Even if the risk involved in Infosys is collectively higher than whole consumer sector’s risk but may be Infosys will be less risky in its industries.
- If the stock is trading 20% nearer to 52 weeks low then it’s a better stock than the stock trailing 20% nearer to 52 weeks high.
- Companies having Debt to Equity ratio more than 2 is a riskier bet than the company with less than 2.
- Companies with less interest coverage ratio are riskier as compared to the opposite.
- Companies having a great equal competitor or in other words, companies with no economic moat are riskier than opposite.
- Companies with low gross profit margin lose when sales decrease (risky) and vice versa.
So based on many factors, risk is assumed. One can’t eliminate risk but can reduce it. The risk is an inbound element of investing. Even great investors make mistakes and lose.
Stock Market is not about being right, it’s about being wrong, far less than others. (Click to tweet)
You might say – Yes! it’s alright but how to determine the risk?
This is a question that I keep asking myself for many years and it’s full of risky secrets. What I’m going to tell you now is going to form the base for considering the risk factor in your investment analysis. SO pay attention.
The risk is no other than the factor you look over before you invest. The favorable factor is less risky and non-favorable factor remains high risk. The following explanation will give you a peek.
There are 2 types of risk associated with stock market:
- Micro level Risks – It’s related to the micro element and fully associated with a sole company. For example:
- The strength of competitor (like moat/brand companies have a low-risk level, small companies are more prone to risk).
- Product quality (low-quality product have high chances to get outdated).
- Management efficiency (transparent management are more reliable).
- Profit margins of the company (high-profit margins can help the company to swallow up the cost in adversities).
- Etc (capital structure, cash flow, returns, cost margins, asset profitability).
- Macro Level Risks – It’s something related to the macro element.
- Interest rate (chances of fed rate hike plunges the whole market)
- Inflation (high inflation can reduce the returns on investment to a great extent)
- Government policies (like the passing of GST bill reduces the risk, hence market climbs).
- RBI Monetary policies (a credit creation action by RBI leads to less risk and opposite in the credit absorption)
- Etc (unemployment rates, price indexes, monetary policy variables, interest rates, exchange rates, housing starts, agricultural exports, and even commodity prices such as gold)
Important – It’s possible to avoid micro level risk but not possible to curb macro level risk because the whole sector or industry is affected from macro risks. A single hike in Fed rate will affect the stock market as a whole. The only way to stay unaffected with this risk is to stay away from market.
Conclusion.
I can tell you wholeheartedly that putting my blinders on to focus on selected stocks of my competence has been one of the BEST decisions I’ve ever made for my investments.
Since starting my investments, I’ve 2xed my returns. This year, I’m expected to hit more. Whoa!
And so, so much of that is because I made the philosophy of “stay inside your circle of competence” one of my primary focuses. It is so dang important and I have seen its fruits firsthand.
There’s more to say but for now. Ta Da!