Baby steps into the investment universe - Risks; Part 3 of 3

Fundamentals 04-3: Learn how to mitigate against risk. There is also a selected URL of free resources for self-learning at the Advanced level and about Risk.  Revision date: 12 August 2020

In Part 2 of 3, I provided the steps to develop your skills in analyzing companies and valuing them. 

What would you do if you are not interested in doing your own valuation but still want to be a value investor?  One way is to rely on other experts to assess and value companies for you.  Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can then just read their analysis and assessment.

But learning to invest in more than that because things do not always turn out the way you expect. You can even lose money. Bad things do happen.

This is risk.  

Charlie Munger has said that all investment evaluation should begin by measuring risk. 

Learning how to manage risk has to be part and parcel of learning how to invest.

But bad things happened not only because of poor skills or even bad luck. It can also be due to your behavior.

In learning how to manage risk, you should also learn about how your behavior can affect risk.

 

In this Part, we will cover the risk and behavioral investing part of the ‘How to invest”.  There is also a list of resources for the Advanced level, risk, and behavioral investing. 

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Contents

• What to Learn

• How to Learn

• 3 risks category

• Risk Mitigation

• Pointers on How to manage risk

• Pulling it all together

• URLs

Case Notes I first published this post on 26 July 2020 under "Is there a way to learn (online, free) to invest (Part 2 of 2) ?" as a guide for those who want to be a better investor.   I subsequently realized that for many, the post is too advanced as they first have to get some basic knowledge about investing.  I encountered a "Star Wars" moment. I needed a prequel.  So this post cannot be the first of the series and I have re-titled and renumbered it accordingly.

What to learn

Risk in the context of “bad things happening” has both a skill component and a luck component.

Since you are unlikely to control luck, you should focus on the skill part.

But your skill in managing risk impacts all levels of the investment process.

At the same time, risk is not a number.  People perceive risks and are prone to biases in the way they estimate risk.

You cannot learn about risk without learning about behavioral finance.

As such this part of the ‘How to invest” post covers:

• Intro to investment risk

• Intro to behavioral finance

• Intro to risk management

I will provide you with a selected list of free online resources for 3 mediums – reading materials, podcasts, and videos. 

Michael Mauboussin has a book about risk and luck titled "The Success Equation, Untangling Skill and Luck in Business, Sports, and Investing”. 

He placed these activities on a continuum with pure luck on one end and pure skill on the other end.

Investing lies somewhere between these 2 ends.  

We are of course trying to improve skills so that luck plays a smaller role.  His insight is that in activities that involve both skill and luck, as skill increases so does luck. 

He calls this counterintuitive phenomenon the paradox of skill.  But read this after you have mastered risk, behavioral investing, and risk management. 

How to learn

There are several stages in the learning process

• Understand risk and behavioral finance

• Identify, assess, and rank risks within the investment process. 

• Specify your risk mitigation plan in the context of your own investment process

In practical terms, risks come into play when you start to invest.  This is when you put in place the risk mitigation plans.

• During the Foundation and Intermediate levels, you focus on learning the concepts.

• You start to put in place the various risk management measures when you are about to first invest.

With this in mind, you should learn about risk at the same time as you develop various analytical skills.  

But pace yourself so that you complete all the risk resources before you first start to invest.

3 risks category

I categorize the risk you face as an investor into 3

• Deterioration of intrinsic value – this could be due to economic or political factors

• Analytical errors – these could be due to misleading information from the financial statements

• Individual issues – these could due to your behavioral issues or your financial position. 

This is the framework in which I learned about the various risk concepts. 

Most people tend to focus on what I called “deterioration of intrinsic values”. 

To them, risks are about issues external to them and hence focus on such items as interest rate risks.

But you also have to be aware of the errors that you can make in analyzing and valuing companies. 

Your biases and other psychological factors also affect risk. 

You have to understand all these 3 categories and I have selected the online resources to cover them.

When it comes to investment risks, there are 2 schools of thoughts

• Those that view risk as some variance 

• Those that view it as a permanent loss of capital

The “variance school” has lots of academic research behind it.  Investment models can incorporate the various mathematical formulae that come with it. 

I have difficulty finding academic papers on the “permanent loss of capital” approach. This is very conceptual with the “margin of safety” as the key mitigation approach.

Since risk is an important part of investing, I have followed both schools of thought.  

• I use Beta and the Capital Asset Pricing concepts in my valuation model

• I also use the margin of safety in the investment decision

When I first started to learn, I used one value as the cost of capital for all the companies.  I assumed that the margin of safety would provide enough cover.

I only incorporated Beta to further fine-tune the valuation after several years of investing.

I would suggest that you follow my approach so that you are not overwhelmed when you first start out.

 

Risk mitigation

“There are few things as risky as the widespread belief that there's no risk because it's only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums.”  Howard Marks, Chairman Oaktree Capital

So you have learned about risks. What do you do next?

Guard against risk by building it into every aspect of the investment process. 

• Identify the risks

• Assess the likelihood of an event occurring

• Put the appropriate mitigation strategies in place

• Monitor the effectiveness of your risk management measures

In trying to put in place the appropriate mitigation measures, I used a framework based on

• the 3-category of risk

• the 4 risk mitigation strategies of accept, avoid, transfer or reduce

Think of a matrix with the 4 strategies on one axis and the 3 risks category on the other axis.

  

Then identify what you would do to reduce risk and the various behavioral issues in each box of the matrix. 

The matrix below summarizes my risk mitigation measures. 

	Deterioration of intrinsic value	Analytical errors	Individual behavioral issues
Accept	Diversify Margin of safety	Margin of safety Be conservative	SOP
Avoid	Quality companies Understand Company Use Beta	Various metrics Quality of earnings Ignore growth	3 buckets Avoid daily news
Transfer	Some monies are invested in unit trusts Some monies are in other asset classes
Reduce	Position sizing Cut loss	SOP Continuous upgrade	Don’t rush Long term

Pointers on how to manage risks

If you have been following my blog, should realize that I am not giving you a system to invest.

Instead, I am providing a guide for you to learn how to invest.

  

I hope that by the end of it, you would be able to set up your own investment and risk mitigation process.

Having said that, there are several pointers on risk mitigation.

I have a Foundation post on How To Mitigate Against Risk When Investing.  

You should read it if not done so and adopt as many of my risk mitigation measures as possible. 

3 Buckets

We all know that there are behavioral risks in investing.  We also know that you need a long-time horizon to be a successful equity investor. We also don’t have unlimited financial resources.

How do you build all these 3 constraints into your investment process? 

I found that the 3 buckets approach is one good way. 

Under this approach, you divide your savings and/or income into 3 buckets

• Have two years of annual expenditure in cash or near cash in the first bucket

• Have another 8 years of annual expenditure in the form that protects the principal. This is likely to be some form of government bonds. This is the second bucket.

• Have the rest of the savings in the final bucket for investing in equities or other risky assets

You rebalance this annually so that the amount in each bucket remains at the original ratio. 

In this way, you maintain enough cash to meet emergencies and not have to sell your risky assets because of this. 

You can then let your stocks ride through any mid to even longer-term gyrations.  OK, you suffer paper losses but as long as the intrinsic value is intact, you can still hold onto them. 

You should adopt this as one of the risk mitigation strategies

Academic research - earnings quality

The reality is that you base your analysis and valuation on the financial statements. 

Any weakness in the financial statements will affect your analysis and valuation.

One way to avoid this is to ignore companies which 

• You suspect are manipulating the financial statements 

• Or even worse have fraudulent practices.

There are academic studies about how to use the financial info to assess whether

• Companies are manipulating earnings

• Companies are getting into trouble.

There are even more direct methods to assess the “quality of the earnings”.

Incorporate such metrics (Altzman, Beneish, Piotroski F-score) into your analytical toolkit.

Document your investment process (SOP)

You cannot avoid the various biases and other behavioral issues even if you are aware of them.  Many are at the sub-conscious level. 

One way to handle this is to have a consistent investment method. One that you stick through.   Have these documented so that it becomes obvious if you start to act differently!

It is more than documenting your investment thesis.  I document 

• How I choose companies to analyze

• Why I chose the valuation method, and 

• My risk mitigation measures.

You should do the same to protect yourself against all the negative behavioral traits.

Continuous upgrade

My investment model today is based on 15 years of accumulated improvements. 

When I first started, it was a simple model.  But as I learned more, I incorporated new parameters.  Occasionally in the process, I discovered some computational errors.

At the same time, I also learned about new valuation techniques. For example, my free cash flow valuation method was based on Damodaran's teachings. Later I learned about the residual income method following Penman's ideas.

To protect against analytical errors, I have incorporated several valuation methods.   

Don’t rush

One trick to reduce behavioral issues is that I don’t buy a particular stock all in one go. Rather I take about a year to build it up to the target size.

Your view of the company may change as you start to put some money into them. 

The reality is that it takes time to understand a company well.

Pulling it all together

• Learning how to mitigate against risk is part and parcel of learning how to invest

• Risk is not a number or an item. It is dependent on your skill and luck. It is also influenced by your behavior

• The first step in learning how to mitigate risk is to learn about the various risk concepts.  These cover risks, behavioral investing, and risk management

• Then develop a risk management plan covering the whole investment process.  Based it on what you have learned

URL

Advanced

No	Site	Guide and comments
Reading materials
1	Damodaran Valuation book	·  Damodaran is the NYU Stern Business School Professor teaching valuation. ·   Use your ingenuity to download his book "Investment Valuation" and take the trouble to learn how to value companies. His website has notes relating to the book ·   You can stop just before the chapter on valuing specific industries and cover them only when you reach the Expert level ·     He also has a series of videos on this valuation class.  You should watch the video in parallel with learning from the book ·       This was one of the sources of my valuation theory.
2	CS Investing	·   This is an investing site with lots of articles and case studies relating to investing and business ·     Under the Tag Cloud you can see a number of topics.  I suggest you start with Buffet, Graham, and Greenwald and read all the material relating to these tags.  It could be articles, Q&A, and even video ·  I found this through Google search and would have bookmarked this site when I first started as I have lots of investing titbits in one place.
3	Street of Wall	·        This site has articles and training materials ·   Go to the Training section and read all those under Investment Banking Technical Training ·     I found this through Google search and I think it teaches you about some of the technical stuff about valuation
4	Investment Masterclass	·    This is a site the list down all the quotations of the great investors ·        Go to Tutorials and read all the articles there. ·       For each series of tutorials start with the Recap and then you can go to specifics ·   Read only a few a day.  Many of these thoughts will become more insightful as you gain more knowledge and experience ·       I use the site to refresh my investment thoughts
5	Value Investors Club	·    This is a site started by Professor Greenblatt for members to share investment ideas ·      The non-member segment has case studies that you should read to get insights on how business analysis and valuation are carried out ·       I still read this regularly
Podcasts
6	Cold Call	·   This is Harvard Business School case studies in podcast format ·        Go through as many of them as possible ·        I found this through Google search.
7	The Investors Podcast	·       The Investor’s Podcast Network covers a wide range of the hottest topics in the financial world. ·    Start with episodes about Warren Buffett and our previous Berkshire Hathaway Shareholder’s Meetings ·        Listen to as many others as you can ·        I still listen to this
8	SME Strategy	·   This is a podcast to help SME. The interviews and discussions on strategy and management will be useful in any business analysis ·     I would start with the episode “Develop a Fortune 500 Strategy for your Small Business” ·      There are 2 categories of podcasts – the “how-to” and the others.  Focus on the others as you are trying to understand the business from the investors’ perspective. You are not management ·       I found this through Google search
9	The Intelligent Investor Podcast	·         This is an interview with great value investors ·         Listen to as many as possible ·         I continue to listen to this podcast
10	Value Investing with Legends	·  This a Columbia Business School podcast on interviews with some of the world’s top investors ·         Listen to all of them ·       One of my favorite podcasts. My main complaint is that are some few interviews
Videos
11	Damodaran lectures	·         Valuation (Undergraduate) Spring 2019.  ·         This is the valuation class taught by Damodaran. ·         You should watch all of them ·         I still watch selected episodes as I refine my valuation model
12	Greenwald Lecture at Gabelli Value Investing Conference	·       Professor Bruce Greenwald lecturing on his Earning Power value approach ·         Watch both parts of this lecture ·   The only regret is that the videos on his classroom lectures are of poor quality (shot by his students) and make it very hard to follow.  That is why I have not recommended them.
13	Iqtan Leadership Strategia	·   This is a discussion about Strategy by Prof. Michael Porter (Harvard Business School) ·     Everone talks about Porter even during my MBA teaching days
14	Kase Learning, Empire Financial Research	·  Kase Learning has many investment case study presentations. You should track and watch all of them. ·        This is one of my favorite sites
15	Investors at Googles, Talk at Google	·         Talks by various investors and CEO ·         You should watch all of them ·         I continue to re-watch some of them

Risk, Behavioural Investing and Risk Management

 

No	Site	Guide and comments
Reading materials
1	Morningstar	·  There is a collection of articles under Risk and Behaviour. Read all those relating to you as an investor ·        Here are 2 specific articles each under Risk 1, Risk 2 and Behavioural Finance article 1, article 2
2	Motley Fool	·         2 Risk articles from Motley Fool article 1, article 2 ·         Behavioral finance articles from Motley Fool article 1, article 2, article 3
3	Yahoo Finance	·         1 Risk article from Yahoo Finance ·         1 Behavioral finance article from Yahoo Finance ·         You will find that most articles talk about similar concepts
4	CFA Institute	·        Article   on Risk Profiling through a Behavioural Finance Lens ·         It shows the link between risk and behavioral finance
5	Financial Mentor	·        Go to Topics, under Investment Advice, go to Investment Risk Management.  Go through all the 2 pages of material ·        I had attended several risk-management courses in my Board role and so I had some background knowledge when I started to invest.
6	CBiz	·         An article I found through Google search on errors in valuation and how to avoid them
7	Deloitte	·        This is an article on the quality of earnings from an auditor’s perspective ·        I have also read similar articles by other accounting groups
8	Credit Suisse	·         Article  on paradox on skills I found on the web
9	CS Investing – James Montier	·        This site allows you to download The Little Book of Behavioural Investing by James Montier ·         You should read the book at the Advanced Level ·         I have read other “Little books” and found them to be quick to digest the contents.
10	Thornton O Glove	·        Use your ingenuity to download this book ·        If you have not done so watch him in Talks at Google ·         I refer to this when extraction info into my valuation model ·        One of the several “quality of earnings” books that I have read ·        Read this at the Advanced level
Podcasts
11	RMA	·        The Risk Management Association has several podcasts on risk and behavioral finance ·         I would start with this one of cognitive biases and decision making ·        You can go to podcasts and see several videos on business and credit risks. Read them as they can help in your business analysis ·         I found this through Google search
12	Behavioural Finance Australia	·        This site has articles, podcasts, and videos dedicated to behavioral finance ·         Focus on equity and with you as the investor ·         I found this through Google
13	My Worst Investment Ever	·        This has a series of interviews about people who have gone through business and investment difficulties ·         I listen to this as a sort of case studies for risks
14	Wealth Track	·        This is actually audio on the 3 Bucket Strategy ·         I thought this has to be part of any risk mitigation strategy when investing in stocks ·         I still watch Wealth Track
Videos
15	Dr. Daniel Crosby	·        This is Daniel Crosby homepage ·         Watch all his videos behavior finance, investment psychology ·         My favorite videos as he puts the concepts in layman terms
16	Pension Craft	·         There are many videos here. ·         Watch those about risk, asset allocation, and investing during difficult times eg recession ·         I found this through Google
17	Andrew Stotz	·        This is a series of Valuation Mistakes and How to Avoid Them ·         You will find this useful when you develop your investment model ·         I found this on Google search ·         Watch this at the Advanced level
18	Berkeley Haas Alumni Network	·         Behavioral Finance and Investment Strategy ·         Watch this after you have gone through one or 2 of the reading materials ·         One of the first video I watched
19	Van Tharp	·         The Van Tharp Institute focuses on teaching trading ·         Watch all the free videos on positioning sizing ·         Although I am not a stock trader, I found that concept of positioning sizing as something seldom covered in a quantitative manner in all the value investment literature ·         I have actually learned to trade online by watching Van Tharp. ·         Watch this at the Advanced level
20	Knowledge City	·         This is a 4- part series of the risk management process ·         You should watch all ·         I found this through Google search ·         Watch this at the Advanced level

End of Part of 3 of 3

Part 2 was published on Sun 12 July 2020

Part 1 (prequel) was published on 6 Sep 2020

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If the above article was useful, you can find more insights on how to make money in my e-book. The e-book is now available from Amazon, Kobo and Google Play.

PS: If you are in Malaysia or Singapore, the e-book can only be download from Kobo and Google Play. 

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