Understanding Risk Management by Tee Leng, ValueEdge.

Very often, investors downplay the need to understand risk management when investing. Many tend to focus more on company valuations rather than risk management due to the lack of understanding of the importance of risk management. In many ways, investing is similar to poker. Only if we are able to preserve our capital, would be still be in the game. Hence, having a good understanding of risk management is crucial in investing and in someways even more so than knowing how to value a company.

What is risk?

Firstly, one of the biggest mistakes many investors make would be perceiving risk as the volatility in stock prices, which is expressed as beta in Modern Portfolio Theory. Contrary to popular belief, such volatility is one that value investors should be anticipating, allowing us to purchase stocks at a cheaper price. To us, the real risk should be the risk of permanent loss of our investment capital. As mentioned above, not losing our investment capital should be the focus when investing.

Initial Percentage Loss Required Gain to Breakeven
10% 11%
20% 25%
33% 50%
50% 100%

Hence, when we suffer a 50% permanent loss on our capital, we actually need our remaining capital to increase by 100% to breakeven once again.

Types of risk

  • Financial Leverage Risk
  • Valuation Risk
  • Industry Specific Risk
  • Black Swan

Financial Leverage Risk. These are the companies that have just too much debt. As long as they hit one setback, it many just set the company back significantly and sometimes permanently. This is evident through the years 2008 to 2009 where we see companies such as Lehman Brothers, AIG, Bear Stearns etc. being hit badly due to their financial leverage. While some such as AIG has managed to survive, others such as Lehman and Bear Stearns have ceased to exist. While financial leverage does have its benefits such as being able to improve the return of equity of such companies, however, it is a double-edged sword.

Valuation Risk. Essentially, this is about not overpaying for our investments. Due to mean reversion, even great companies would tend back to normalised levels. Hence, by overpaying for such companies would essentially just mean a loss in our capital. Furthermore, even if we were to be buying companies based on the cheapest decile of any valuation metric, caution has to be taken. Understanding of how earnings have been changing over the years and adjustments to one-off gains/losses have to be made when coming to a rough gauge of the company’s valuation.

Industry Specific Risk. This is where companies in a specific industry has been hit badly, such as in recent times the entire oil industry have been negatively hit due to the low oil prices. By just concentrating our portfolios in one specific industry may not be that good an idea, especially when we are faced with an industry-wide depression. Just look at the packaging industry where valuations have been depressed for nearly 10-years.

Black Swan. Such cases are events that are random and unpredictable. Events such as the Russian Government’s debt default in 1998 or the SARS Crisis that hit the entire market were occurrences that came as a complete surprise.

In Summary

Understanding the importance of risk management and the various types of risks, I will touch on how we can actually conduct risk management when investing in a subsequent post.