Risk is something every investor has to deal with. You can never truly remove all risk from an investment. You can only seek to reduce risk as much as possible, but even then, something may turn up that was not known at the time of your initial analysis.
Seeking to reduce risk with every investment opportunity is the best chance you have to skew the odds in your favor. There are four methods you can incorporate into your strategy to reduce risk.
Leverage
Debt and leverage are probably the biggest threats to any business’ existence. A little debt can be helpful, but having excessive debt on the balance sheet can lead to problems.
From an investor’s perspective, companies that have room on their balance sheet to lever up have more space for growth through acquisitions and organic opportunities as well as reducing the overall risk of the investment.
If a company has net cash on its balance sheet and a strong base of tangible assets that exceed liabilities, the chances of it going to zero are slim. The easiest way for investors to reduce risk is not to have leverage themselves.
The margin of safety
The margin of safety is a fundamental principle of value investing. If used correctly, it helps to reduce risk and maximize upside.
The margin of safety works in two different ways. First, it makes sure you never overpay for a company. If you maintain your discipline, only buying when a particular discount to intrinsic value is available, the margin of safety will help you generate substantial positive returns.
Second, the margin of safety gives you room to be wrong. No analyst, no matter how good they are, will ever be able to calculate a 100% accurate intrinsic value for a company. There is always going to be some variation on each side.
What’s more, even if you can calculate an accurate intrinsic value, there is no guarantee the share price will ever reflect this. The margin of safety helps to mitigate the effects of mistakes in analysis and protect against unknown and unforeseen market and company-specific stresses.
Know your investment
One of the reasons whyWarren Buffett (Trades, Portfolio) has been so successful as an investor is his focus. When evaluating Coca-Cola (KO, Financial), his most famous investment, he analyzed the reports of the business dating back 100 years. Sometimes such detailed analysis is not possible, which is why Buffett has a “too hard” pile.
If you cannot understand a business, what makes it tick and what the potential risks are to its survival, you are only increasing your level of risk. Arguably, it is easier to invest in small caps for this reason as they are much easier to analyze and you can understand the company you are buying without having to make certain assumptions.
If you spend several years studying companies, you quickly realize how many different ways there are for management to manipulate earnings, sales, revenues or balance sheets. The only way to ensure there are no hidden risks is to understand every element of the business.
Temperament
The final strategy to reduce risk is to have the right temperament for investing. You are significantly increasing the risk attached to your portfolio if you are not prepared to ride the market's ups and downs. Efficient analysis consists of thousands of small judgements while researching a company, and you need to make and analyze those judgements with a clear head.
Removing emotional biases and other behavioral traits that will influence your decision is essential if you want to improve your temperament. Unfortunately, there is no quick fix to this last problem. Improving your temperament is a constant process.
Disclosure: The author owns no stock mentioned.
