Risk is a Three-Legged Beast

The way I see it, there are three sources of risk when investing.  The first is the company whose shares you’re buying, the second is Mr. Market, and the third is you.

Company/Business risk

This is the risk that the company either doesn’t pan out the way you thought, or it goes bust or gets taken over or does something stupid that permanently damages the intrinsic value of the business.

You have some control over this, and this is what all the analysis effort goes into.  How will it do, what will the profits be more or less, will it keep trading through your holding period, will that catalyst appear; those sorts of issues.  For bottom-up value investors, this is what it’s all about.

Market risk

This is Mr Market’s speciality.  It’s basically the risk of making a loss due to a change (downward) in the share price or of the portfolio as a whole.  To most value investors, this is utterly irrelevant, or at least it should be.  Mr. Market is there to serve you and not to guide you, and the basic premise of value investing is that Mr Market makes a lot of mistakes and that he’s either a bit stupid or mad or both.  He’s definitely not the sort of person whose opinion you want to listen to.

Value investors come to their own independent conclusions about the likely value of a business by doing fundamental research.  If Mr Market offers them an opportunity to buy it at a significant discount from that value, then they’ll take him up on his offer.

If he subsequently decides that the company is worth only half what it was before and drops the share price by 50%, the value investor is supposed to be even happier because there’s an opportunity to buy this asset at an even lower price.  Of course, that’s assuming company risk hasn’t appeared, and the company is actually worth less than it was before.

On its own though, a falling share price means nothing, and the market is efficient enough so that you really do have absolutely no way of knowing which way the share price is going in the next few days, weeks or months.

The real risk of market risk is that it can cause you to buy and sell at the wrong time, which is known as…

Behavioural risk

This is where you come in.  Probably the biggest risk of them all, and certainly the most important, is the risk that you’ll do something stupid or at least bad for your future wealth.  On the assumption that you’re a human, then you’re likely to have a slew of behavioural quirks that might be good in social situations and for wrestling tigers, but they’re a big hindrance when it comes to investing.

One risk is that you’ll stop saving so much during bull markets.

Another risk is that you’ll buy whatever has had the biggest price appreciation (note that I didn’t say value appreciation) in the last year (shame on you if you’re a value investor).

Or, on the flip side, you might sell when the market drops out of fear, thereby changing the irrelevant market risk into realised and highly relevant behavioural risk.

Or perhaps you’ll have a good run for a year or two and start getting big-headed and lazy with your analysis, load up with crummy stocks and take a huge fall from grace.  Trust me, it happens.

The best way to control these risks is to do good, methodical analyses, ignore Mr Market when you need to and have a well-thought-out battle plan for every step of your investment process so that you’re not making decisions on the hoof.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

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