The ultimate Q&A to Investment Risk 101

Investing tips 03: The original version of this article was published in March 2021. It was part of a series of investing advice that has been collated from my Quora responses. It has now been updated to include specific answers to what are risks, how to identify and assess them, and how to mitigate them. Revision date: 22 Sep 2021

"Given a 10% chance of a 100 times payoff, you should take that bet every time." Jeff Bezos

One of the first terms that I came across when learning how to invest is risk-reward or risk vs opportunity.

We all agree that risk and opportunity are two sides of the investing coin. There are those that avoid the stock market because they fear the risk. At the same time, there are many who are attracted to the stock market because of the perceived returns.

While we all understand returns, risk is a bit more complex. This is especially if you are a value investor and follow the idea that risk is not volatility but a permanent loss of capital.

While there are lots of resources on volatility as risk, there is hardly any on managing risk from a permanent loss of capital perspective. I thus had to tap into my corporate risk management experience to develop a comprehensive way to identify, assess and mitigate risks.

This post is part of a series meant for newbies. I focussed on answering the questions from the view of a bottom-up, stock-picking, long-term value investor.

I am coming from the perspective that you are interested to learn how to invest based on fundamentals. This requires you eventually to analyze and value companies.

If you don't want to do this, but still want to invest based on fundamentals, there are many third-party advisers who can do this for you. A good example is Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

1. What is risk?

2. How to identify and assess risk

3. Risk mitigation measures

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1. What is risk?

In investing there are 2 schools of thought when it comes to risk.

Those that view it as volatility.

Those that view it as a permanent loss of capital.

The former has lots of academic credentials. The theory has developed to a stage where risk can be modeled mathematically. Furthermore, risks are separated into systemic and non-systemic risks. You can diversify the non-systemic risks. You live with the systemic risks by demanding higher returns for the higher risks you take.

Unfortunately for us value investors, there is very little academic research into the permanent loss of capital.

Some would consider risk as to the likelihood of not earning what you expect. I don’t think making less is not the same as losing some of the capital.

Over the years, I have suffered such permanent loss of capital from 3 situations:

Selling during a temporary price drop thereby converting the temporary loss into a permanent loss. I think I no longer have this risk having learned to invest for the long term. At the same time, I do not invest using borrowings so that there is no pressure to sell an investment at the wrong time.

A deterioration in the intrinsic value to permanently below the purchase price. Over the past 15 years, I have had 3 cases of such losses. Two were due to outright fraud by the companies while the other was due to business risks.

Privatization by the controlling shareholders. There have been occasions where I have benefited from a privatization exercise. But there were a few privatization exercises where the offered price was below my purchase price. OK, you can argue that I should have bought the shares with more margin of safety.

The moral of the story is that you have to differentiate between the effect (losing some of your capital) and the reasons (cause of the loss) if you are going to manage risks effectively.

There is another difference between volatility and permanent loss of capital as risk. With the latter any loss is permanent. It cannot be reversed. The best you can do is cut loss or look at other ways to make back the loss. That is why learning how to invest and taking preventive measures are critical.

1.1 What is the difference between non-diversifiable (systematic) risk and diversifiable (unsystematic) risk?

In the finance world, there are 2 views of risk:

Those who see it as volatility.

Those who see it as a permanent loss of capital.

The volatility school has lots of academic support and the theory has developed to a stage where “risk" is separated into 2 - those that can be diversified away and those that cannot.

The theory then says that the undiversified risk has to be borne and we should expect greater returns the greater the risk we bear. To practice this concept, you have a diversified portfolio of 30 companies to take care of the unsystematic risk and then pray for good luck to take care of the systematic risk.

OK, I am being facetious but it boils down to this in practice.

The permanent loss of capital, however, doesn't have the academic theory behind it although there are many proponents - generally value investors.

This school believes that you can get more returns with lower risk. Unfortunately, there no is theory but lots of practical ways to achieve this.

Personally, I believe in the permanent loss of capital concept as it allows me to address all the things that can go wrong when I am investing rather than say that there is a portion that I have to pray for.

If you view risk as a permanent loss of capital you will agree that risk is not a number. I have not come across any calculation of this.

But if you follow the “variance" school of risk then you can do so.

1.2 How can you avoid financial risk?

There are 2 schools of thought when it comes to risk

Those that view it as volatility

Those that view it as a permanent loss of capital

The volatility school has strong academic credentials and the theory states that risks can be separated into systematic and non-systematic risks. You can diversify away non-systematic risks while for the systematic risks, the Beta gives a good measure of the risk. You cannot avoid this Beta so you seek a higher return for taking on higher risk.

The permanent loss of capital school doesn’t have much academic support and the proponent doesn’t believe that you can quantify risk. Having said this, you can adopt a host of measures to mitigate risk.

If you talk about stock picking based on value investing then I can group the risks here into 3:

a) Those due to deterioration of the intrinsic value due to changes in fundamental resulting from economic, political, etc factors

b) those due to analytical errors eg due to creative accounting by companies, wrong assumptions

c) those due to behavioral biases

The risk here is of course permanent loss of capital.

There are ways to mitigate the above risks. Not full proof but hopefully can minimize the loss of capital. Note that I ignore variance as a risk as I have a long-term ie years investment horizon.

If you want more detail visit Is Eksons a value trap? (Part 1 of 2). This is my analysis and valuation of a company where I also cover risks. It shows how you bring risk into the company analysis.

I have not found any book that teaches you about risk management from a permanent loss of capital perspective. Most of the books on investment risk talk about it from the “variance school”

Secondly, while there are books on risk mitigation strategies, I have not found one that specifically focuses on risk from a permanent loss of capital perspective.

So over the years, I have learned to establish my own risk plan to cover the permanent loss of capital angle and I have detailed it in my post “How To Mitigate Against Risks When Value Investing”

Risk is a complicated topic but is not a number. It is an attitude to minimize all the things that can go wrong and/or minimize the impact when it happens.

Also, the risk is not some external happening. Your behavior also causes risks.

1.3 How can I regain my invested money?

If you have incurred the loss by actually selling the investment, take it as a learning experience.

The only way to “recover” is to learn to invest and achieve consistently good returns in the future.

But if it is a paper loss, you have to assess whether it will lead to bigger paper loss or that it will eventually recover. The only way you can do this is if you have learned how to invest.

The point is that you have to learn how to invest.

1.4 If a stock gets "delisted", what happens to the money you invested?

Actually, when you buy stock, you are exchanging your money with a piece of paper that says that you are a part-owner of a company. In the old days, it was an actual piece of paper. Nowadays in most countries, it is digitalized.

When a stock gets privatized and is delisted, you still have that piece of paper. Just that there is no public market where you can sell that piece of paper easily.

You don’t have any more money until and unless you sell that piece of paper. You will have to find a buyer and sell it and the selling rules will have to follow the articles of incorporation of the company.

No buyer = no money back.

You are now a shareholder of a private company. If you are lucky you get some dividends in the future.

You will continue to be a shareholder until you sell. You have to check the articles of the company to see whether there are any conditions for the sale. The challenge for the sale is finding buyers and getting the price.

I have 3 or 4 companies that went private - treat it as worthless and you won't spend time agonizing about them.

I was lucky that one did go public again.

2. How to identify and assess risks

If you consider risk as a permanent loss of capital, then your risk plan should start from the top.

Have an asset allocation plan so that you manage risk and return for all your savings. For further details refer to “Baby steps in Asset Allocation for a Value Investor”.

For your stocks, do not invest only in one stock. Have a stock portfolio that you construct and manage from a risk-averse perspective. For further details refer to “Baby steps in constructing a stock portfolio” and “Baby steps in maintaining a stock portfolio”.

Establish a risk management plan for your stock investment process.

If you follow the volatility school, there is a lot of literature on identifying and assessing risk.

According to Investopedia

“One of the principles of investing is the risk-return trade-off, where a greater degree of risk is supposed to be compensated by a higher expected return. Risk - or the probability of a loss - can be measured using statistical methods that are historical predictors of investment risk and volatility. Here, we look at some commonly used metrics, including standard deviation…”

However, you have to take a different approach when comes to the permanent loss of capital. I have developed a risk management framework comprising of several elements:

The Ishikawa diagram to identify the root causes of a permanent loss of capital.

A Threat Matrix to assess the likelihood and impact of each of the risks.

A Risk Mitigation Matrix to ensure that we have measures to mitigate each root cause.

Refer to “The best way to reduce investment risk” for details of each of the above components.

2.1 How do you assess the S&P 500 Index fund as an investment risk, and why is it considered a very safe index to invest in?

It is considered a safe investment in the sense that you earn the market returns (minus the fees of course).

But it does not protect you against losing money (my definition of risk) if you don't have a long-term investing horizon. The market can do down and if you sell when this happens, investing in an index fund is not a “safe” investment

The main point is that risk has a behavioral element. So if you don't learn to mitigate against this, there is no safe investment out there.

The goal of investing is to generate a return. Risk comes when there is some chance of losing your invested capital.

Whether an index fund protects your principal depends on which index you invest in. I am sure that for the US and most developed nations, the index fund has grown over a 10 to 20 years period.

If you are in those countries where the growth in the index fund is not so clear cut, you will have to consider other investments eg real estate.

Secondly, an index fund is not the only investment that can protect your capital. Bonds, real estate offer the same protection even in the developed countries.

When you invest you are balancing return with protection. Since different investments behave differently in various economic situations, you probably want a wider choice than just one index fund.

2.2 How do behavioral biases affect investment decisions?

When you invest, there are 3 decisions:

What to buy?

How much to buy?

When to buy?

From a value investment perspective, the buy and sell decisions are based on the market price relative to the intrinsic value.

But to derive the intrinsic value, you have to understand the business and make assumptions about its prospects, etc. These affect your valuation. Any biases you have then affect your valuation and hence your buy and sell decision.

When it comes to how much to buy, this is generally dependent on the amount you allocated to the total portfolio and the number of stocks you want to hold. At the same time, unless you allocate an equal amount to all the stocks, the likelihood is that you will allocate a bigger sum to the stocks with the highest conviction.

Again, you can see how behavioral biases affect this decision.

Can you mitigate these? There are several things that I do:

Have a standard procedure.

Don't listen to the news.

Don't rush into things.

Take a long-term view.

The reality is that behavioral biases are only one of the risk elements in investing. There are others that have an equal impact so that if you want to manage risk you need an overall approach.

Investing success is dependent on behavior rather than intelligence.

2.3 What is investment risk tolerance and can an individual analyze it?

I like to think of it as the % of your savings you can afford to lose without fretting about it.

A 100% risk-tolerant person is one who thinks nothing of losing 100% - these are the addicted gamblers.

Then there is the 0% risk-tolerant person who gets upset even losing 1%.

When it comes to investing, there are 100% risk-tolerant persons - just imagine those who blindly trade/invest.

However, I don’t think there is any 0% tolerant person. To invest you need some risk tolerance.

Having said that, being some 10% to 20% risk-tolerant doesn’t mean that you simply trade/invest. In other words, being risk-tolerant does not mean that you sit back and accept the risk of losing money.

There are a host of measures to adopt so that while being risk-tolerant, you end up with a minimal permanent loss of capital.

I have seen several “questionnaires” over the years that try to establish your risk profile for investment purposes.

At the end of the day, if you are knowledgeable about investments, you don't need a questionnaire to tell you your risk tolerance.

Warren Buffett has the saying that risks come from not knowing what you are doing. I think this aptly describes my point.

3. Risk mitigation measure

Once you have identified and assessed the various causes of risks, I adopted the four standard risk mitigating strategies.

Accept: With some risks, the expenses involved in mitigating the risk are more than the cost of tolerating the risk. In this situation, accept the risks and carefully watch them.

Avoid: In general, avoid risks that involve a high probability impact for financial loss and damage.

Transfer: Mitigate risks by sharing or transferring them.

Reduce: The most common mitigation strategy is risk limitation

What you actually adopt will depend on your own situation. My measures include the following

1) Adopt a conservative approach in the valuation. Use conservative estimates for the various valuation parameters. For example, if there are growing trends for the profits and/or cash flows, any valuation that assumes zero growth will be conservative.

2) Have different levels of the margin of safety depending on the nature of the investment. For example, have a larger safety margin for companies going through a turnaround compared to one with a "consistent" track record. I also choose companies with some dividend track record as I consider dividend payment as some form of margin of safety.

3) Focus on quality stocks and those with a long operating history to guard against fraud and the business environment. I have incorporated a number of academic quality and risk indicators in my analysis. Examples are the Beneish M Score, the Piostroski F Score, and Altzman Z Score.

4) Diversify. I adopt a 2-tiered diversification plan. Firstly, I invest in several asset classes with equity as only one of them. Secondly, I hold a portfolio of about 30 to 40 companies. These are from different sectors, market capitalization categories of investments. (Refer to the valuation posting to see how I categorize my investments)

5) Understand the company. Get a good picture of how it got to its present position. Understanding its business model and strategies helps me get a handle on its fundamental and macro-economic risks.

6) Invest in the long-term. This helps to mitigate any short-term economic upheavals.

7) Be prepared to cut loss if the investment thesis is no longer valid. I have done this several times. While there are some initial losses, I can more than make up for the losses by investing the money in other companies with better prospects.

8) Invest more in those where you have more confidence. This is related to the position sizing strategy.

9) Incorporate Beta into the valuation. When I first started, I used one discount rate in my valuation. To account for the risks, I now use the Capital Asset Pricing model to determine the discount rate.

10) At the end of the day, the best risk mitigation strategy is to look at the investment from the downside protection perspective. Let the upside take care of itself. Don’t think of the returns that can be made. Rather think of how to prevent losses.

3.1 What are some techniques for reducing risk in investing?

I have a 2-tiered risk plan:

First to allocate your net worth using the 3 buckets. This will determine how much of your net worth is set aside for risky investments.

Have risk mitigation plans for the risky investment

The buckets concept is about dividing your net worth into 3:

Have 2 years of annual expenses in cash - bucket 1.

Have another 8 years of annual expenses in assets that protect the principle eg govt bonds, properties.

The balance in bucket 3 are for risky assets

The 3 buckets plan will ensure that you are not forced to sell risky assets at the wrong time to meet emergencies. At the same time, you also have some base savings that you do not risk.

Another way to mitigate any forced selling is to avoid leverage. If you buy stocks with leverage especially very short-term borrowings, you might be forced to sell in case you do not have the funds to meet any top-up requirements and/or repayment requirements.

Then for the risky assets, different asset classes and investment styles will require different risk mitigation plans.

For stocks from a value investing perspective, I have a list of things

Diversify.

Know the company you are investing in.

Take a conservative approach in valuing the companies.

Take a long-term view.

Have a margin of safety.

Focus on quality stocks.

I also use a risk matrix where one axis I have the 4 risk mitigation strategies - avoid, accept, transfer, and reduce. The other axis is for all the risks which I categorize into 3

Due to changes in fundamentals.

Due to analytical errors.

Due to behavioral issues.

3.2 What do you call someone who invests their own money into different asset classes like a business, real estate, stocks, etc?

If you know which asset will give you the best return, you will be an idiot not to invest in it.

Unfortunately, you don’t know how the future will turn out so you spread your investments into several assets in the hope that if one does badly, the others do well enough to more than offset the bad one

This is the asset allocation problem:

How many assets to invest in?

How much to invest in each asset?

You should have at least 3 asset classes:

Liquid assets eg cash to cover emergencies so that you don’t have to sell the other assets at the wrong time.

Safe assets eg those that protect the principal to serve as a floor net worth in case your risky assets all tank. These also serve to give returns when the risky assets experience some bad years. Examples are govt bonds.

Risky assets. These are the ones that generate the best returns historically eg stocks, real estate.

The reason for having all the various assets is that each of them does well in different economic situations. I follow Ray Dalio's concept of having the portfolio cover 4 economic scenarios resulting from a combination of inflation vs deflation and economic growth vs depression.

So, what do you call a person who has his net worth into the various assets? A risk avoider. It is all about risk mitigation.

3.3 What are the advantages and disadvantages of the index model compared to the Markowitz procedure for obtaining an efficiently diversified portfolio?

If you buy the index, conceptually you are buying the “market” so you don’t really have to worry about whether you have selected the correct stocks.

On the other hand, if you are selecting your own portfolio of stocks, you have to worry about whether you have selected the “best” stocks. This is where the challenge is - how do you select stocks.

If you belong to the school of thought that views risk as volatility, then one way to select is to use Modern Portfolio Theory - the Markowitz model. Here the “best” stocks are ones that lie on the “efficient frontier” and the model says that for a particular risk level there is one stock combination that gives the best return.

It is heavy computation and I have never been able to go beyond 3 stocks doing this on Excel. I am very sure the majority of the retail investors would not be able to mathematically determine the “best” stock using this model.

And we have not even covered the part of whether volatility is equivalent to risk in investing.

The other school of thought is the permanent loss of capital one that believes that you can expect higher returns without taking on more risk.

There is no specific mathematical model to help construct a portfolio here. Rather you build up your portfolio using a host of risk mitigation measures. Some of the measures apply at the portfolio level eg

Have a diversified portfolio where there is no concentration in one particular stock or sector.

Hold more stocks for those with higher conviction

Then there are other measures that cover the analytical and selection process eg

Have margins of safety when buying.

Be conservative in your analysis.

Buy what you know

The permanent loss of capital school is about risk management. And you can talk about risk management without fancy maths.

3.4 Isn't stock picking in the end mostly luck, given how any edge really comes down to your predictions about the prospect of the business?

While I would agree that being able to analyze and predict the prospects of the business is an important part of investing, there are ways to put the odds on your side.

The best analogy is the casino. The house always wins in the long run because the odd and betting systems are set in their favor. The player always loses in the long run.

So, when you invest, you want to be the casino and not the player. How can you do this?

If you are a value investor, firstly you invest with a margin of safety. If the computed intrinsic value of a stock is for example USD 100 per share, then you only buy if it is trading at say 20 % to 30 % below this.

Secondly, you use very conservative approaches in determining the intrinsic value. Thirdly, you don't bet on one stock. You have a portfolio.

In the context of a casino, think of the games you can play:

There are those who want to play the slot machine because it is a mindless game of luck. There are those who play poker as there are some skills involved.

If you are likely to play the slot machine, don’t invest in stocks as you are pure gambling and are likely to lose. But if you want to develop certain skills first before investing, you have a better chance of making it.

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