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You've most likely heard of diversification and rebalancing as good ways to reduce risk in your portfolio. But some of the best investors in the world don't agree with those. Warren Buffett is against diversification and calls it a protection against ignorance. However, prominent investors such as Ray Dalio and most financial advisors advocate diversification and similar risk management strategies. The reason for these opinion differences is that risk is defined differently by different investors. In today's post, I want to introduce you to the real definition of risk and give you a practical approach to reducing it regardless of whether you are in camp Warren or agree with Ray Dalio and most financial advisors. I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.
This post is part of our educational series to help you hone your fundamental investing skills. Catch up with past blog posts on How to Invest Like Buffett? How to Invest Like Charlie Munger, or how to Find the Highest-Returning Stocks? Remember, this content is for education and sharing ideas and not advice to buy or sell any securities. Sign up for a free account on Stock Card to get notified of these blog posts, YouTube videos, and Podcast shows every week. We only ask your name and email address when you sign up. What's Portfolio RiskCommonly, stock market investors assume risk is equal to volatility. For example, if a stock goes up and down more than the overall market, it is considered risky. There is a technical term for it, too. It's called Beta. A stock with a beta above one is deemed more risky, a beta of one means a similar risk as the overall market, and a beta under 1 means a stock is less volatile than the overall market. Again, commonly, to address the volatility, the prescription is to diversify your portfolio across multiple sectors and geographies and rebalance your portfolio regularly to avoid a few winners taking a significant portion of it. But Beta isn't really equal to risk. By definition, risk is a situation where you are in danger. What's the danger in the stock market? Losing your money. When a stock goes up and down significantly, it doesn't mean you will lose your money. In particular, you are not in danger when you understand why a stock moves and don't sell the loser just because the price has gone down. A stock price may go down even if there is no problem with the company's fundamentals due to an overreaction to the news or macro factors. It's also possible that there is a real problem with the company's revenue or profit. The first scenario is not dangerous, the second one could be. Very successful investors such as Howard Marks, billionaire investor and co-founder of Oaktree Capital define risks as the probability of permanent loss of capital. It means you take more risk in your portfolio if stocks the stocks you own have a higher probability of going down to zero, not because they are volatile. For example, I told you earlier that investors commonly use a technical indicator called Beta to measure risk. Amazon's Beta is 1.56. By definition, this means investing in Amazon's stock is riskier than the overall market. But, it is impossible to assume you will be in danger of permanently losing your money if you invest in Amazon even though it fluctuates more than the overall market. I'm not saying there is no risk in investing in Amazon. However, as long as Amazon has a growing eCommerce, cloud services, and advertising business, and you invest in it at a reasonable price, the risk of losing your money is not higher than the overall market. The risk in investing in Amazon comes from your behavior. If you panic and sell when Amazon's stock price goes down, if you don't keep up with Amazon's business and don't understand how it makes money, those are the real risks. Real Sources of Portfolio RisksTaking it back to your portfolio and using the new definition of risk as the probability of permanent loss of capital, how do you reduce risk? You look for companies that have a higher probability of falling apart. Here are a few reasons for a higher likelihood of big losses:
I'm not saying you shouldn't invest in those companies. However, if more than 50% of the holdings in your portfolio have one or all of the six factors I just listed, you are taking a real risk of permanently losing your money. How to Identify Hidden Risks In Your PortfolioTo apply this step, go back to your portfolio, review each individual holding, and put an X in front of it for each of the six factors we just discussed. Count how many holdings have at least one X in front of it, and divide it by the total number of stocks in your portfolio. The result shows a rough likelihood of you losing your money. Are you comfortable with that number? If not, in 2024, your task is to replace those companies with other companies that have lower real risk. It requires some time to research each stock, but the effort is worth it. You may also be comfortable with the probability of losing money. This is a very personal decision and goes back to your financial situation. The number itself doesn't matter. But it matters that you are comfortable with it. If you watched to this point, I know you are already committed to leveling up your investing skills and developing your best portfolio. The good news is that we launched a coaching program to help assessing the risks in your current portfolio and setting up the foundation for the best portfolio you can create. Visit the course page to learn more and sign up. I'll see you next time! NEW COURSE IN 2024 |
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