What is the best way to manage risk?
There are many different views on this subject. Many wealth managers will tell you that the best way to manage risk is to have a well-diversified equity portfolio. The same can be said for fund managers.
Another tactic is to invest across different assets with low correlations. And if you are clever, you can use the same approach used by the worlds largest hedge fund, Bridgewater.
Bridgewater’s funds are designed to achieve returns in any environment by investing in many different asset classes based on computer-compiled models.
While all of the above methods have been shown to work well as methods of diversification, some studies have shown it is not necessary to have more than 20 different positions to be well diversified.
To understand this idea you need to be able to know the difference between risk and volatility.
Manage investment risk with research
Risk should not be confused with volatility. True risk is the risk that you will take a total capital loss on your investment. Volatility, on the other hand, is a result of the day-to-day movements of the market.
Ultimately, true risk comes from not knowing what you are doing. And the best way to diversify away from this risk is to do your research and understand every opportunity down to the most minute detail.
“Targeting investment returns leads investors to focus on potential upside rather on downside risk … rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk.” — — Seth Klarman Margin of Safety
Investing is not an easy way to make money. It requires hard work and constant reading to be able to do the needed due diligence on any investment.
Spending hours studying a company, its prospects and financials might not seem appealing. It might also not be practical for the weekend investor (a strong argument for indexing for non-professional investors), but it is essential if you want to reduce risk significantly.
“Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return. Anyone would enjoy a quick and easy profit, and the prospect of an effortless gain incites greed in investors. Greed leads many investors to seek shortcuts to investment success. Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips. They do not stop to consider how the tipster could possibly be in possession of valuable information that is not illegally obtained or why, if it is so valuable, it is being made available to them. Greed also manifests itself as undue optimism or, more subtly, as complacency in the face of bad news. Finally, greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation.” — Seth Klarman Margin of Safety
Unfortunately, there are no shortcuts for research (a stock screener only gets you part of the way there). If shortcuts did exist it’s unlikely that the best opportunities to profit would ever exist at all.
Even though you can take shortcuts to reduce risk, alternatives such as diversification, having a margin of safety and only investing in companies with a robust cash balance, you will never actually know what makes the business what it is without spending hours studying assets, liabilities and revenue streams. This attention to detail will protect you from making silly mistakes, or repeating the same error many times over.
If you’re betting on nothing than the stock price, that’s fine but it should be nothing more than a price-based trade. For example, if you think, that after a 25% rally, the stock can continue to add another 10%. If the stock then falls 15%, saying “I’m a long-term investor I will continue to hold” without spending time considering the fundamentals, will likely end in disaster.
Fund managers use diversification to reduce risk, holding 50 or more positions to show their investors that they are with their fees. In many ways this is lazy. A well-diversified portfolio hints at the notion that you’re using diversification to make up for your lack of research. If you know your investment inside out, then there’s no need to diversify.
There will always be unknowns
“The future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survey and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his of her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.” — Seth Klarman Margin of Safety
Having said all of the above, it is never going to be possible for the average investor to know everything about a business. That’s why a margin of safety is critical in all investments.
If you get to know your target inside out and buy with a deep enough discount to intrinsic value, based on a range of outcomes, not only should you be able to achieve much better returns than a well-diversified investor, but your risk of loss should be greatly reduced as well.