The best way to reduce investment risk
Fundamentals 12: This an update on the risk management framework pulling together the threads from my various risk articles. However, instead of publishing it in my blog, I have guest posted it in a US value investing site ‘Investing for Beginners.”
Contents
- Background
- Tapping into my experience.
- How best to reduce investment risk.
- Investing for Beginners.
- Risk management project.
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Background
I am a self-taught value investor who learned the various valuing investing concepts from free online resources. That was almost 2 decades ago.
Today there are more online resources for those who want to go through the same self-learning route.
With hindsight, for anyone wishing to follow the self-learning route, I would advise that they cover 4 different subjects:
- Value investing concepts - buying a bargain, Mr market, margin of safety.
- How to analyze companies - moats, management, prospects.
- How to value companies - relative valuation, asset-based valuation, and earning-based valuations.
- Risk mitigation - permanent loss of capital rather than volatility.
When I first started to learn about value investing, there was lots of information about the first 3 topics. But looking for risk materials from a permanent loss of capital perspective was a challenge.
Even today, the challenge remains.
Sure, there are lots of risk articles if you view volatility as risk. But for value investors, the risk mantra is “permanent loss of capital”.
I found that most value investment sites talk generally about considering risk as a permanent loss of capital. But very few have specific advice on what to do.
This is unlike the volatility school. There are lots of academic studies on volatility as a risk. The theory has reached a stage where there are mathematical models for risks. Risks have been are categorized into systemic and non-systemic ones. You manage the non-systemic risks by diversification and you handle the systemic ones by asking for higher returns.
You can imagine the predicament I faced. I know how to analyze and value companies. I invest with a margin of safety. I am told to focus on the downside and let the upside take care of itself.
But apart from these 2, there is not much else on risk management from a permanent loss of capital perspective.
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| Ishikawa diagram |
Tapping into my experience.
I then had to develop my own risk management process.
I was fortunate as I had served as a member of the Audit Committee in several listed companies since the 90s. Over this period, the focus of the Audit Committee had shifted from internal audit to corporate governance. And corporate governance began to focus on risk management.
I tapped into my corporate risk management experience to develop my risk management framework.
The other fortunate thing was my engineering background. In my early work life, I worked in factories looking after quality management among other things.
That gave me the opportunity to be familiar with quality control tools. The one that I remembered best was using the Ishikawa or fishbone diagram to trace defects.
Whenever there is a defect, you first list down all the possible causes. At this stage, this is merely guesswork. There could be several causes for a defect. Some are direct, some are indirect. Some are second-level effects.
I used the Ishikawa diagram to help frame the cause and effect so that you can identify the root causes. You then formulate measures to eliminate the root causes.
Two things can happen. If you are lucky, you don’t see the defects anymore.
Most of the time, the defects still occur. When this happens, the conclusion must be that the activity that you tackled was not the cause. You then move on to another suspected cause.
You then update the Ishikawa diagram.
To cut a long story short, I used the tools from the factory and Audit Committee experience to develop my risk management framework.
Actually, it was not only a trial-and-error process but also a rambling and iterative one. What you see today is a framework that has gone through several rounds of improvement.
I consider the version today as my risk management 4.0.
How to best reduce investment risk.
I have a series of articles in my blog and other publications (Seeking Alpha, Medium, and SlideShare) relating to risks.
Each of them covers specific topics. Even for those that I have repurposed for other publications, there are nuances to them so that it worth a read.
I suggest that you read them all so that you can have a better understanding when you try to implement the risk management framework.
When I wrote the articles, they were not based on some particular sequence. However, with hindsight, I would suggest that you read them in the following order.
1) Introduction to risk
2) Global approach to risk
3) Risk management framework
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| Threat Matrix |
Risk management framework.
I have presented a risk management framework comprising 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.
This framework is based on viewing risk as a permanent loss of capital.
Risk is not some number. It is about some events that can lead to a permanent loss of capital. If you take this view, then risk mitigation should involve every stage of your investment process.
- Start with an asset allocation plan.
- Dovetail this into your stock portfolio.
- Adopt the corporate risk management process to assess risk and bring it into your investment process.
Risk management involves identifying the threats, assessing, and then mitigating them. I used the Ishikawa diagram to help identify the threats. Next, consider both the likelihood of the risk happening and its impact. I used the Threat Matrix for this.
You then formulate the mitigation measures based on 4 strategies. These are avoiding, reducing, accepting, and transferring the risk. This is what I called the Risk Mitigation Matrix. You have to read the guest post to see an example of this.
As mentioned, the post is presenting the framework and showing how to tie the various elements together. I shared what I have done to illustrate how to handle some of the challenges when implementing the risk management plan.
Rather than post it in my blog, I have it as a guest post in a US value investing site - Investing for Beginners. Visit the post “How To Best Reduce Investment Risk – A Comprehensive Framework” to learn how to do it.
Investing for Beginners
Investing for Beginners is a value investing resource founded by Andrew Sather. According to him, it is
“…to help you decode the jargon of the market, investing, and finance. You can get started on your path to financial freedom TODAY, by reading through the blog, listening to the podcast…or subscribing to my free email newsletter for daily tips.”
There are lots of free materials on stocks and value investing on that site. For those non-accountants and non-finance newbies, the site has good articles on how to learn the accounting and financial concepts required for value investing.
My own Investing for Value blog is not exactly a site for newbies. It is meant for those with some basic knowledge of value investing.
That is why I am looking for some sites where there are free online materials for newbies so that you can learn the basics. You can then better benefit from my blog.
Investing for Beginners is one such site.
You know my mantra. Value investing requires you to be able to analyze and value companies. If you want to invest based on value investing principles but do not have good enough analytical or valuation experience, you should seek third-party advice.
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 tap into their business analysis and valuation.
Risk management project
In the investment risk management guest article, I have presented a template to
- Identify the investment risk.
- Assess them by looking at the impact and likelihood of it occurring.
- Formulate the risk mitigation measures.
I have presented what I have done for my investment process as an example. As mentioned, my current version is based on my research so far and I know that it is probably not the final version.
I want to tap into the wisdom of the crowd to improve it. As such I am inviting all investors to share their fishbone and Risk Mitigation matrices with me.
My hypothesis is that irrespective of how you frame the fishbone, there will be a universal list of risk mitigation measures. Each investor can then pick from this universal list to meet his particular investment process. Help me develop this list.
If you would like to collaborate on this research, email your fishbone and Risk Mitigation matrix to i4valueasia@gmail.com.
I will share my findings with you. My target is to collect 100 versions.
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