Habit #5:
Understand risk
This is the hardest habit to form, simply because most of us investors never count risk as part of the equation. And those who do, have a fuzzy idea of what ‘risk’ really means.
This is the hardest habit to form, simply because most of us investors never count risk as part of the equation. And those who do, have a fuzzy idea of what ‘risk’ really means.
In
general terms, investing risk refers to the uncertainty of the occurrence of a
certain event that can affect future returns. But ask Buffett, and he would go
a step further. Buffett defines risk as ‘permanent loss of capital’.
As per
this definition, risk is to lose whatever you’ve invested and not have any
chance to get it back. Short term fluctuations in the stock prices, therefore,
don’t equate with ‘risk’, as is generally considered in the investing circles.
So the
good idea for you to become a smart investor is to understand what risks you
are taking while investing in stocks.
Before
buying a stock, try to answer this question – “Can this stock cause a permanent
loss of capital to me?”
If your
answer is ‘yes’, or even ‘maybe’, you better stay away from that stock. Buying
it despite knowing that it would involve risk-taking would be foolish.
Of course
we can never eliminate risks from stock market investing, but we surely can
minimise the chances of the same.
I believe the whole series of this articles (#1, #2, #3, #4, and #5) will help us to reduce the risk significantly.
As per my earlier articles, there are 2 types of risk faced by stock investors - (1) Capital Risk, and (2) Timing Risk. To mitigate the risk, I will guide myself only buy a good companies (to reduce capital risk) in a huge margin of safety (to reduce timing risk).
"Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety." - Benjamin Graham
"A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss." - Seth Klarman
