Having discussed some of the various risk in our previous article, so how do we actually minimise such risks?
Personally, I believe the key to minimising such risks is through diversification by holding approximately 20 to 30 stocks in the portfolio. I do understand that there are many investors who prefer taking concentrated positions, putting their money in a few of their best ideas. Buffett probably helped popularize this idea by focusing on his “twenty punch card rule”, while Charlie Munger is famously known for saying that 3 stocks is enough. However, how confident and experienced are we to really just take on a portfolio of say 5 companies?
Imagine the case of a portfolio consisting of 5 companies versus a portfolio consisting of 25 companies. This translates to a 20% and 4% capital allocation for each case respectively. While it is true that if we are right in our investment thesis, the former portfolio would lead to us earning out-sized returns. However, what about our downside risk? Imagine if just one stock turned out to be a fraud or some zero probability event were to occur. A 4% loss is something much easier to stomach than a 20% loss in our portfolio. Furthermore, a 4% loss is still something we can easily recover from.
A common mistake I see amongst investors who do diversify, would be that each stock idea is based on different strategies. There are many financial blogs and sites out there where the author’s shares their stock picks. While we may all be value investors, it is just a generic term. Some of us may believe in a GARP strategy, Deep Value, Special Situation, Event-Driven etc. Buying a stock from each type of strategy isn’t really considered diversifying. One is essentially committing the mistake of the law of small numbers. Hence, this is one of the biggest and most common mistakes I observe amongst my peers committing, when trying to diversify.
Lastly, I believe one of the biggest checks to minimise risk would be ensuring that you aren’t buying fraudulent companies. Study and identify the common patterns and traits of past fraudulent companies – the balance sheets, the cash flows and the footnotes. Check the insider trades, are the CEO and Directors buying or selling their shares? These are extremely strong indicators in giving one an idea whether the company is fraudulent. True, this this by no means the most accurate way in identifying fraud, however, it is sufficient to filter out most of it.
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