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02 May 2009

UNDERSTANDING RISK

Whenever I speak to someone who is not an investor in the stock market (hereinafter called as the 'disbeliever'!), the oft heard refrain is that there is too much risk in the stock market. "See what happened last year", I am told before being given the 'look' which says, 'I know what I am doing with my money thank you. Nothing good ever came out of risking it in the market'.

There is risk in the stock market. 
As there is in bonds, realty, commodities and heck, even in gilt.

EXPECTATION RISK
The first risk in the stock market is of expectation. If I expect the stock to give 20 % dividend and it gives 10%, well that's a risk I had taken when investing. This risk arises not out of the losses, a business is going to suffer but my lack of understanding of the issues at hand. Businesses will fluctuate and I must understand the fluctuations and invest accordingly. For if I understood that the business would not generate enough profit, I could either lower my purchase price or give it a go-by altogether.

So in order to lower my expectation risk, I have to :-
(a) Increase my depth of understanding.
(b) Be conservative in expectation/ assessment.
Both of the above are cornerstones of value investing.

TEMPORAL RISK
The second risk a stock investor takes on is temporal. If I expect the stock to deliver 25% Compounded Average Growth Rate over five years and it does so for four of those and not for the fifth (remember 2003 to 2008!!), I run the risk of being forced by events (in this case, my cash flow requirements) to sell at an inopportune moment.

Temporal risk occurs as a result of loss of value of a stock. However, unless this value is realised through actual sale, it remains notional. Hence it stems from the DNA of the funds used. If they were meant for the college education of the daughter, t'were better if not invested or if invested, then extracted when the going was good and not be timed to perfection.

So in order to overcome temporal risk, I must be prepared to go to the mattresses and wait out for the long haul. Hence the need to invest in the stock market with money, the requirement of which, does not dictate your sell decision.

THE BOTTOM LINE. Invest in the market after understanding what you are doing, with money you do not need for the investment horizon.

AN ASIDE. One thing good about the concept of risk is that it allows a lot of people to earn their daily bread and then some more, by carrying the stage name of a 'risk manager'!

RISK, LIKE GOD, IS INSIDE US

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This blog should not be construed as investment advice, either on behalf of particular stocks or in regard to overall investment strategies. It is a site aimed at understanding competitive advantages and valuing businesses. The information provided here comes from publicly accessible sources, but errors in these sources and in transcription may occur. Any investment decisions you make should be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs.