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Have you ever seen those commercials where a regular person is walking down the sidewalk and then, out of nowhere, an NFL linebacker rushes him for a massive tackle?
Those are pretty hilarious, I know…
But it isn’t as hilarious when I tell you that your portfolio is about to suffer the same fate.
How do I know this?
Well, if you’re like most value investors, you’re paying a lot of attention to your margin of safety, and potential gains, without taking a long hard look at the risks involved in your investments.
You’re probably in worse shape if you’ve come from a business background and are just stepping into value investing, though.
You see, business sometimes has silly twists on concepts that we use intuitively in everyday life.
One of these concepts is the concept of risk.
In everyday life we understand what risk is and talk about it with other people in a way that’s easily understandable.
The basic understanding is that risk is bad, it involves loss, and its something that should usually be avoided.
Modern finance, for some reason, has taken our traditional concept of risk and replaced it with the notion of risk as volatility.
In other cases, business leaders have been taught that higher investment returns are available only if risk increases.
This is poisonous thinking.
If you’re a long time value investor, then you already know that risk does not equal volatility.
Risk is the chance of real loss.
But, do you know how to leverage this concept of risk to safeguard your life savings?
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While volatility does have a place when talking about risk, the problem comes when volatility replaces the overall notion of risk and leads to less then optimal decisions.
That’s a polite way of saying it.
As those who requested free net net stock ideas already understand, sometimes this twisted thinking can be outright dangerous.
Focusing on a misguided concept of risk means focusing on the wrong things when it comes to trying to control risk.
To see how this new concept of risk leads investors astray lets see what would happen if we used it in ordinary life.
Risk in the business world is typically understood as the chance that actual results will deviate from expected results.
In other words, risk is the chance that what actually does happen in the real life case is different from what you expected to happen.
When I was a kid, I had to take a city bus home from school.
Fortunately for me, the the bus that swung by my school didn’t go past my house, which left me waiting at the local mall for an hour to catch a second bus to complete my trip home.
Being a kid, one day I naturally wandered into K-Mart’s electronics department looking for video games.
As I approached, I could see the games sitting there in the corner, but then I caught a glimpse of a sign sitting beside them.
As I got closer, I began to tremble.
On that sign was written, “50% off”.
Video games were rarely on sale, so I asked the closest clerk if the sign was intended for the games or something else.
He responded by telling me that the games were on sale, but that the sign was wrong.
They had actually been discounted by 90% but the sign hadn’t yet been changed.
My 13 year old heart nearly stopped beating.
Now, the finance concept of risk would label these games as risky, since their price had been beaten down to insane levels.
Buying them, the finance concept of risk would imply, would be a risky move.
But, I was well aware of prices in the used game market.
Ignoring the advice of the academics, I ended up buying nearly half of the store’s inventory and then reselling it to other video game dealers for roughly 250% over my purchase price.
I made a huge amount of money in only a few hours.
That was the day I became a value investor.
What Risk Actually Is
Risk is loss.
More accurately, it is the amount that a person can potentially lose and the chance that the loss will occur.
Taken together, these two pieces make up risk: the amount that can be lost and the chance that a person can actually lose it.
Deep down inside we have always known this.
It’s an aspect of life that we have discussed with others when we caution them about a course of action.
When we talk about the dangers of drinking and driving, for instance, and we condemn it for the risk it poses we mean to say that the result of a traffic accident can be catastrophic and that alcohol increases the chance that an accident will occur.
We do not say the same thing about, say, drinking and walking.
We don’t think that the chances of a collision when you drink and walk is lower.
It may even be more likely to bump into someone while drunk than crash your car while drunk.
We don’t condemn drinking and walking, though, because we understand that the consequences of colliding with another person is substantially less sever while drinking and walking than drinking and driving.
In the case of drinking and driving the risk is that we will cause serious injury or even death.
The chances of this happening are substantially higher than when we drive sober.
Our intuitive concept of risk also accounts nicely for gambling.
If we agree to a certain payout based on the flip of a coin the risk increases dramatically based on the dollar amount used.
If I call the flip of a coin wrong (chance) and have to pay you 50 cents as a result (loss) then the risk to me is fairly minimal.
It is certainly much smaller than if I had to pay you $1000.
In both cases the chance of loss is held fixed but the amount that I could potentially lose is much greater in one case versus the other case. It is the case where I have potential to lose $1000 that the risk is intuitively understood to be a lot higher.
Varying the chance of loss also varies the risk. Imagine that instead of having to pay you $1000 after getting 1 coin flip wrong I had to pay you $1000 after I called 20 coin flips in a row wrong.
The chance that I would get all 20 coin flips wrong is microscopically small.
We understand that this case is much less risky than the case in which I would have to pay out $1000 after just one flip.
It may seem like this is nit-picking but an accurate conceptual understanding of risk has large consequences.
As soon as you understand what risk actually is, in business and elsewhere, you immediately recognize risk in all its forms.
It is also easier to see how risk does not lead to higher returns but actually erodes returns by causing losses.
Conversely, guarding against risk can actually boost your overall returns.
Spot These Investment Risks In Advance!
Risk is fairly obvious when it comes to investing in stocks – it’s the chance that you’ll lose money.
And I’m talking about a real loss, not a short term paper loss.
A real loss happens when an investment suffers a somewhat permanent decline in stock price or an erosion of value of the original investment due to inflation.
In both cases value is destroyed.
When it comes to common stock investing investors will usually encounter risk in 6 different places. If you do a good job of guarding against these six sources of loss, your overall returns will inevitably be higher.
The first category of risk is price risk
This risk is essentially buying a stock at too high of a price due to improperly valuing it, or buying it above a sound value. These two are very similar, but in the first a value is thought to be established, while in the second a value is not taken into account.
Mis-valuation can happen when the wrong assumptions are used, or calculated incorrectly.
Wrong assumptions include things like discount rates, earnings growth projections, and past data not being representative of present or future conditions.
With this risk, the stock is bought and then falls back to intrinsic value, but an intrinsic value you didn’t count on.
The second category of risk is the erosion of value
Those lovable round cardboard cutouts that you’d throw a large plastic puck at…?
One day someone in my class showed up with a few. The next day most of my classmates had bought some. By the end of the week, everyone had them and one of my friends has spent 4 months worth of his allowance on designer pogs and custom cases. Yes, those things were cool…. for about a month.
Sometimes your original assessment of value just doesn’t holdup.
After you establish some value for the firm, that value shrinks for whatever reason.
If bought below net asset value, one of the firm’s assets might suffer a large write-down.
If your company has stumbled onto the fact that people in its home town love salisbury steak, it may make a lot of money… until 5 other restaurants open nearby, or customers start getting food poisoning.
Competitive pressures, product failures, a client exodus, or escalating costs, as well as a dropping price for the investments held by the company, such as stocks, bonds, or subsidiaries, can be devastating.
Imagine how those Pog dealers faired when the mass of enthusiasm dried up virtually overnight and they were stuck with thousands of small cardboard disks.
The third category of risk is interest rate risk or market risk
Market risk is the risk of the entire market falling to a lower valuation, and your stock falling along with it.
This risk is irrelevant for valuations based on arbitrage, and can have a smaller impact on a solid net net stock portfolio.
You see the stock of a company that you’re interested in.
It’s trading below a market multiple. You buy based on its relative undervaluation but then the market drops.
Sure, there’s a chance that your stock faired better than its peers — but that would be cold comfort if you bought tech in the late 1990s.
Interest rate risk is a type of market risk in that it effects the entire market, but is different because it can have different effects on different companies. The risk here is essentially that interest rates are increased, which would lower the level of the market.
It would hit companies such as Harley Davidson disproportional hard, since sales would fall because it would be more expensive to finance a motorcycle at higher interest rates.
If you own one of the rate sensitive stocks, the value of your company may be impaired, or may suffer insolvency.
Financial risk is the next category
This is the risk that your company will become insolvent.
Traditional screens of financial soundness apply here, such as the current ratio, interest coverage, or debt levels, as well as newer measure of financial health, such as the Altman Z-Score.
As the life and death of Ablemarle & Bond Holdings shows, debt can be devastating.
Time risk is the fifth category of risk
This risk is the risk of your investment taking an abnormally long time to rise to intrinsic value.
This could happen for two reasons, most notably neglect by the market, but it could also be possible that you have bought into a situation that will take a very long time to work out.
The longer it takes for the investment to come to intrinsic value, the lower your average yearly returns.
Eventually a point can be reached where inflation has eaten up the value of the funds invested.
Fraud is another risk that has the power to kill
Sometimes people just lie. Often this has a large negative impact on your portfolio.
Names such as Bernie Made-off are well known and highlight just how devastating fraud can be. Fraud happens far more than you may realize, however, but on a much smaller scale.
It’s a sort of risk that you’ll always expose yourself too, but it can be minimized.
You may be surprised that I’ve included volatility in this list, especially given my previous criticism of using it as a definition for risk.
If you’re counting on receiving a specific amount of money at a specific point in time, on the other hand, volatility can be a huge risk.
You wouldn’t want to invest your rent money at the start of the month, for example, if you needed at least the value of your principle back by the end of the month to pay your rent.
Volatility can also devastate you if you have a weak stomach for it.
If you’re the type of person who gets worried when your stock starts ticking downwards, then volatility might cause you to liquidate your holdings at the exact time that you should be doubling down.
Identifying the Problem is a Critical First Step
Identifying the sources of risk is a necessary first step to being able to deal with risk prudently.
Investors can actually do quite a bit to limit the risk that they’re exposed to — but doing so requires a shift in how you look at investments and some solid critical thinking.
This is one of the reasons I started investing in net net stocks.
I’ll be back in a later article showing you exactly how I use my Net Net Hunter Investment Scorecard to limit the risk of any one of my holdings.
Until then, feel free to join 2000 other value investors who are getting free net net stock ideas. Click here for more information.
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