How NFL Football Can Help You Avoid Investment Losses
Have you ever seen those commercials where a regular person is walking down the sidewalk and then, out of nowhere, an NFL linebacker rushes him for a massive tackle?
Those are pretty hilarious, I know…
But it isn’t as hilarious when I tell you that your portfolio is about to suffer the same fate.
How do I know this?
Well, if you’re like most value investors, you’re paying a lot of attention to your margin of safety, and potential gains, without taking a long hard look at the risks involved in your investments.
You’re probably in worse shape if you’ve come from a business background and are just stepping into value investing, though.
You see, business sometimes has silly twists on concepts that we use intuitively in everyday life.
One of these concepts is the concept of risk.
In everyday life we understand what risk is and talk about it with other people in a way that’s easily understandable.
The basic understanding is that risk is bad, it involves loss, and its something that should usually be avoided.
Modern finance, for some reason, has taken our traditional concept of risk and replaced it with the notion of risk as volatility.
In other cases, business leaders have been taught that higher investment returns are available only if risk increases.
This is poisonous thinking.
If you’re a long time value investor, then you already know that risk does not equal volatility.
Risk is the chance of real loss.
But, do you know how to leverage this concept of risk to safeguard your life savings?
While volatility does have a place when talking about risk, the problem comes when volatility replaces the overall notion of risk and leads to less then optimal decisions.
That’s a polite way of saying it.
As those who requested free net net stock ideas already understand, sometimes this twisted thinking can be outright dangerous.
Focusing on a misguided concept of risk means focusing on the wrong things when it comes to trying to control risk.
To see how this new concept of risk leads investors astray lets see what would happen if we used it in ordinary life.
Risk in the business world is typically understood as the chance that actual results will deviate from expected results.
In other words, risk is the chance that what actually does happen in the real life case is different from what you expected to happen.
When I was a kid, I had to take a city bus home from school.
Fortunately for me, the the bus that swung by my school didn’t go past my house, which left me waiting at the local mall for an hour to catch a second bus to complete my trip home.
Being a kid, one day I naturally wandered into K-Mart’s electronics department looking for video games.
As I approached, I could see the games sitting there in the corner, but then I caught a glimpse of a sign sitting beside them.
As I got closer, I began to tremble.
On that sign was written, “50% off”.
Video games were rarely on sale, so I asked the closest clerk if the sign was intended for the games or something else.
He responded by telling me that the games were on sale, but that the sign was wrong.
They had actually been discounted by 90% but the sign hadn’t yet been changed.
My 13 year old heart nearly stopped beating.
Now, the finance concept of risk would label these games as risky, since their price had been beaten down to insane levels.
Buying them, the finance concept of risk would imply, would be a risky move.
But, I was well aware of prices in the used game market.
Ignoring the advice of the academics, I ended up buying nearly half of the store’s inventory and then reselling it to other video game dealers for roughly 250% over my purchase price.
I made a huge amount of money in only a few hours.
That was the day I became a value investor.
What Risk Actually Is
Risk is loss.
More accurately, it is the amount that a person can potentially lose and the chance that the loss will occur.
Taken together, these two pieces make up risk: the amount that can be lost and the chance that a person can actually lose it.
Deep down inside we have always known this.
It’s an aspect of life that we have discussed with others when we caution them about a course of action.
When we talk about the dangers of drinking and driving, for instance, and we condemn it for the risk it poses we mean to say that the result of a traffic accident can be catastrophic and that alcohol increases the chance that an accident will occur.
We do not say the same thing about, say, drinking and walking.
We don’t think that the chances of a collision when you drink and walk is lower.
It may even be more likely to bump into someone while drunk than crash your car while drunk.
We don’t condemn drinking and walking, though, because we understand that the consequences of colliding with another person is substantially less sever while drinking and walking than drinking and driving.
Drinking and walking…… not quite the same level of risk.
In the case of drinking and driving the risk is that we will cause serious injury or even death.
The chances of this happening are substantially higher than when we drive sober.
Our intuitive concept of risk also accounts nicely for gambling.
If we agree to a certain payout based on the flip of a coin the risk increases dramatically based on the dollar amount used.
If I call the flip of a coin wrong (chance) and have to pay you 50 cents as a result (loss) then the risk to me is fairly minimal.
It is certainly much smaller than if I had to pay you $1000.
In both cases the chance of loss is held fixed but the amount that I could potentially lose is much greater in one case versus the other case. It is the case where I have potential to lose $1000 that the risk is intuitively understood to be a lot higher.
Varying the chance of loss also varies the risk. Imagine that instead of having to pay you $1000 after getting 1 coin flip wrong I had to pay you $1000 after I called 20 coin flips in a row wrong.
The chance that I would get all 20 coin flips wrong is microscopically small.
We understand that this case is much less risky than the case in which I would have to pay out $1000 after just one flip.
It may seem like this is nit-picking but an accurate conceptual understanding of risk has large consequences.
As soon as you understand what risk actually is, in business and elsewhere, you immediately recognize risk in all its forms.
It is also easier to see how risk does not lead to higher returns but actually erodes returns by causing losses.
Conversely, guarding against risk can actually boost your overall returns.
Spot These Investment Risks In Advance!
Risk is fairly obvious when it comes to investing in stocks – it’s the chance that you’ll lose money.
And I’m talking about a real loss, not a short term paper loss.
A real loss happens when an investment suffers a somewhat permanent decline in stock