There are many ways for investors to reduce risk. Diversification, using a wide margin of safety and only investing in companies with little or no debt are all, in themselves, ways to reduce risk. Together they can make a powerful combination. The most robust way to reduce risk, however, is probably the easiest of all.
Due diligence is an essential part of the investment process, but it is a part of the process a large number of investors skip. Everyone has heard the stories of fund managers on Wall Street who do not bother to read quarterly reports or annual reports and just charge in, following the herd. It is this herd mentality that has been attributed to the underperformance of active managers over the long term.
Due diligence is essential
A rigorous due diligence process is vital if you want to reduce risk to a minimum. 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. Indeed, you may think you are in a company with little or no debt, but what happens if debt is held off the balance sheet or comes in other forms such as leases and pension obligations?
A contract cancellation or unexpected expense could also suddenly deplete the cash balance, leaving investors to pick up the pieces. A rigorous process of due diligence is also required to calculate an accurate intrinsic value, the most important part of finding a margin of safety.
No shortcuts
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.
If you look back at some of the biggest business frauds and corporate collapses in history, the likes of Bear Stearns, Lehman Brothers and Enron, with hindsight, it is clear the risks of investing in these companies were hiding in plain sight. Those who were prepared to dig deep and find out more about these businesses, the likes of Jim Chanos (Trades, Portfolio) and Michael Burry, could see disaster was only just around the corner.
Of course, you will never be able to know everything about a company. There are always unknown unknowns; this is just part of doing business. Even if you plan for every eventuality, some unforeseen development may always be just around the corner. Nonetheless, if you do rigorous due diligence, your chances of being taken by surprise should be reduced.
The father of value investing Benjamin Graham said many times that as a shareholder you are an owner of the business, not just the holder of a lottery ticket. You have to ask yourself: "If you are going to buy a business, would you purchase the business sight unseen without conducting any research into it and what it does?" The answer to that question is probably no. Then why would you establish a position without first understanding everything there is to know about the business? Granted, this is a daunting task, but it is required if you want to be able to reduce risk as much as possible and, more importantly, generate the best returns.
Warren Buffett (Trades, Portfolio) reportedly read 100 years worth of annual reports for Coca-Cola (KO, Financial) before he invested. This knowledge of the business gave him not only the conviction to invest, but the confidence to hold through the good times and the bad, giving him the fortune he has today.
If you are looking for a shortcut or someone to do the research for you; I am sorry to disappoint, but there is no shortcut for hard work. If you do not do your due diligence, how are you supposed to have any confidence in the business when the market eventually turns against you? There is no other way of putting it; if you want to reduce risk to the lowest level possible, hard work, focus and a deep understanding of the business is required.
Disclosure: The author owns no stock mentioned.
