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Don’t lose money.
When it comes down to it, investing is about not losing money. The best way to do that is to understand and mitigate the inherent risks that are part and parcel of putting up capital. Although a value investing approach is a low-risk strategy, investing is by nature a risky activity and no philosophy or style can insulate one completely from risk.
That said, here are a few ways by which value investors seek to control, manage and moderate risk.
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Margin of Safety
It is a terrible feeling to purchase shares in a company and watch its price drop. Margin of safety can help with that particular feeling.
The father of value investing, Benjamin Graham was the first person to popularize this term; it refers to the idea of buying a security when it trades below its intrinsic value. Intrinsic value, of course, is the true value of a business, or what a company should be worth if you could put a dollar value on all of the tangible and intangible parts of the business.
It’s a bit like only buying an item when it goes on sale. Value investors are like soccer moms in that respect, waiting to buy that flat screen TV when it becomes heavily discounted during the Boxing Day Sale.
In the short run, it’s entirely possible for the stock market to experience wild swings in price. A stock trading at $100 could be $80 tomorrow and $135 the day after that. However, if you identify and purchase a stock trading at a considerable discount to intrinsic value, you gain a built-in safety net.
Consider the case of Horsehead Holdings, a company that used to be the largest zinc oxide and zinc metal producer in the US. They are currently going through bankruptcy proceedings and their share price collapsed from $20 to just under 2 cents a share, placing their market capitalization at $1.15 million.
The interesting part is that on their most recent 10Q, they have listed their plant and equipment as being worth $200 million. The liquidation value of the company is way more than their market cap, and very simplistically an investor could swoop in, purchase the company for a bargain price and sell off all the assets to make a quick and tidy profit.
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The famed value investor, Seth Klarman built his successful fund by emphasizing the margin of safety concept. In fact, his book “Margin of Safety” has achieved a cult like status among the value investors. Copies regularly change hands at $1000 or more.
Keep a Lid on your Emotions
If you don’t keep a check on your emotions, then it is unlikely that you will have a good time investing in the financial markets.
A study by Dalbar Inc. found that the average investor tends to underperform the S&P 500, even though the most common stock market advice people get is to invest in the S&P 500 and hold on for the long run. For a 20 year period between 1992 and 2012, the S&P 500 returned 8.21% per year; the average investor returned just 4.25% over the same time frame.
The study cites bad investor habits as the reason for this underperformance, and bad habits stem from a lack of proper emotional control. Many people allow their emotions to guide their investing decisions and one of the best ways to control your investment risk is to practice the habit of investing unemotionally.
The worst time to make an emotional investing decision is when things aren’t going your way. It’s a times like these when an investor needs to slow down, and re-assess the reasons they decided to hold a position in the first place. Having actual reasons when the investment was made helps in this case, as well as having an investment plan written out, detailing when and under what circumstances the investment should be liquidated.
Warren Buffett himself says that temperament, not intelligence is what separates the great investors from the rest of the herd.
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Use checklists
Using an investment checklist is a great way to control for risk before an investment is ever made. It prevents an investor from making rash decisions, by forcing them to move in an organized and step by step manner.
A business can seem like a slam dunk, but using checklists slows an investor down, giving them the opportunity to do their due diligence. Types of items that can feature on your checklist include questions such as “Have you reviewed the performance history”, or “Do you know the earnings announcement schedule?”
Checklists are not a substitute for proper research, rather they serve to catch mental lapses inherent in every person.
Know what risk is
Value investors view risk differently than other investors, and can be broken down into two main parts: the first is fundamental risk and the second is agent risk.
Fundamental risk comes from not understanding the fundamentals of the company or business you own. Put simply, it’s buying a car that turns out to be a lemon. The other risk stemming from fundamental risk is the potential to overpay for a company. Conducting adequate research and being conservative can mitigate this type of risk.
Agent risk, on the other hand, has to do with an investor’s ability to stick to their plan and how emotions can cloud one’s ability to execute on a plan. This happens when volatility causes an investor to deviate from the plan, or because one doesn’t truly understand why the investment was made in the first place. That is why writing out your investment thesis and the conditions under which the investment is made and when it will be terminated can be beneficial in keeping yourself on the straight and narrow.
Finally, there is what everyone else considers to be risk but what value investors understand as being irrelevant, or sometimes even helpful, to the overall picture. Volatility, or how much the price of your asset moves by, is what a lot of people consider as investment risk. However value investors know that volatility, especially short-term volatility, is an unavoidable part of investing in the markets and something one can even use to their advantage.
Let volatility improve your entry and exit points in stocks, making the irrational behavior of the market work to your benefit.
After all, you understand that true risk is the potential of permanently losing your capital over the long run.
In addition to margin of safety principle and stoic approaches, proper position sizing and transactional decisions can also reduce risk of capital loss.
Further Reading
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.