There are two methods of protecting yourself from the risk of making a loss. Diversification and the margin of safety approach. These are key strategies to reduce risk in your investments. Warren Buffet become the world’s most successful investor using the margin of safety approach. However, Tony Robbins believes diversification is probably the best strategy for the average person. Which is best for you?
Now, in my previous articles I introduced you to the Investment Framework and I also explained the basic concepts that you need to understand before you get started. By now you understand the overall system that you need to work with. For example, you need to:
- Clearly define your goals and know how much they will cost
- Figure out what return you need
- Determine how much risk you can tolerate
- Understand your constraints are (time horizon, liquidity needs, taxes, legal and regulatory, unique circumstances)
- Pick the assets you want to invest in.
- Calculate how much you can contribute.
How do you actually do this stuff?
What I am going to do now is explain practically, how you can figure all of this out. Over the coming articles I will explain the following:
- How you can use this framework to avoid losing money
- How you can use it to protect your kids’ future
- And how you can use it to beat the lousy savings rates from the banks.
How you can avoid losing money
In this article I am going focus on how you can avoid losing money in your investments. Right now, you may be wondering “what can I invest in that isn’t going to disappear with the next economic collapse?” Or maybe you struggle with uncertainty? Perhaps you are wary after reading the small print. That is, the small print that stipulates, investments can go up as well as down. This makes potential gains seem not worth taking the risk.
And maybe you don’t know where to go or who to ask about where you can put your money. Its hard to be certain that you’re being given sound investment information. Either way, you want to be able to invest at a tolerable risk. Well in this article I’m going to explain how you can do it.
What is risk management?
Risk management is how investors avoiding making losses. I have done this for years at many banks. There are two broad ways that investors manage their risks. One is by establishing a margin of safety. The other is through diversification.
Margin of safety
What do we mean by a margin of safety? How can we apply this to our investments? Honestly, this depends on the kinds of investments that you want to make. This is less important if you are going to be investing in index funds. If you invest in index funds you can take advantage of diversification to manage your risk.
How you manage your risk depends on your personality.
On the other hand, if you want to invest large amounts in a small number of investments, then building in a margin of safety is important. This largely depends on your personality. Some people only feel comfortable if they have full control over their investments. If you are this type of person you will probably prefer to invest in real estate. You probably prefer to be able to see and feel your investment. It is literally “real” hence the name.
Stocks probably seem abstract. The stock price on a healthy company can go down on any given day. How does that make sense? The value of a stock can sometimes seem divorced from the performance of the company. Whereas if you buy a house to rent, the income stream is predictable. And house prices generally rise over time. But what about when you have a housing market crash? How do you prepare for that?
How do we manage risk?
Imagine that you are driving your car. We don’t think about it often but driving is an inherently risky activity. Tens of thousands of people die on American roads every year. About four times as many Americans die from car crashes than are murdered with guns. You’d think car accidents would be in the news more often!
Let’s say that it’s a bright moonlit night. You’re on a wide four lane highway. The weather is clear. And you’re driving a brand-new Volvo – a car with a great reputation for safety. You might say that your risk of having a serious car accident in these conditions is pretty low. As such, you can feel comfortable driving fast. The conditions are good and so you can take a few chances.
Now say it’s a stormy night it’s pouring with rain. You can barely see 20 feet ahead. You’re driving a rusty old Ford with bald tires. You’re on a single lane, windy country road. There’s lots of traffic coming the other way. So now you have to establish a really wide margin of safety with your driving.
How do you do this? Maybe you drive slower. And you give yourself more room between your car and the car in front. You try to anticipate problems before they occur.
How does the margin of safety work in investing?
How does this relate to investing? Well many of the banks I worked for invested in real estate. Some of the properties were high quality like the Volvo above. Others were more like the old Ford with bald tires. With a high-quality property, we can afford a smaller safety margin. What would that look like with our investment?
Our investments were debt investments (loans). With a loan you have to consider the Loan to Value (LTV) ratio. Say that you had a brand-new office building that had been sold for $100m. If it is good quality we might lend the buyer $75m. This is a 75% LTV ratio.
But what if the property is of poor quality. Let’s say an old office building that needs some work to modernize it. There are no tenants. This means that there is no rent and no way for the owner to immediate being paying our interest. We will have to wait until after he has refurbished the property.
We would class this as high risk. To compensate we would need a wider safety margin. So, if the building cost $10m we might lend £4m. This is a 40% LTV. This helps make up for the additional risk that we are taking on. At this level of LTV our margin of safety is 60%. The property value would have to fall by more than $6m before our investment was at risk of a loss. A 60% cushion is very comforting.
How does this work with stocks?
With stocks it’s a little bit different. As a shareholder you are similar to the purchaser of the property in the above examples. How do you manage your risk?
Well Warren Buffet has an ingenious way of managing risk. We know its ingenious because he’s the most successful investor of all time! So, what does he do?
Do what Warren Buffet does…
Warren Buffet looks at stocks that represent good quality companies. These companies are always well managed. They are companies in industries that Warren Buffet knows well. For example, as child Warren Buffet delivered the Washington Post and also sold magazine subscriptions. Many decades later, in 1973 he began buying shares in the Washington Post.
At the time that Warren Buffet bought the Washington Post it had fallen out of favor with investors. But it was still a solid company. We know that because in spite of the challenges for newspapers today, the Washington Post is still with us.
So where does the margin of safety come in here?
Warren Buffet is the most famous adherent of this principle but he learned it from Benjamin Graham. Benjamin Graham was a famous investor of the 20th century. He lost almost everything in the Stock Market Crash of 1929 but made it all back in the years following. He wrote several books based on research and his own experience, including The Intelligent Investor. I highly recommend this book if you are keen on buying individual stocks.
Intrinsic value
Benjamin Graham used the notion of Intrinsic Value to pick stocks. This means that by projecting the company’s future cash flows and discounting them to the present he could find out the true value of the stock. How do you do this? The same way you would calculate how much you need to save for retirement. I discussed the method in a previous article.
Because of the complexity of this calculation I will dedicate a full article to it at another time. But let’s look at a simple example. Imagine you are looking at a stock that’s priced at $110. You have determined that the intrinsic value is $100. You would conclude that this stock is overvalued.
In this case, depending on the quality of the company, Warren Buffet would apply a 50% discount to the intrinsic value. That means that he would wait until the market price of the stock was $50. A bargain. This of course assumes that the stock price hasn’t fallen because of some calamity at the company.
If the intrinsic value is still $100 then you are in a very good situation. At some point the market price of the stock will rise from $50 to $100. A 100% return! This assumes all other things to be equal of course. It is unlikely that you will make losses from this investment.
Individual investments are a lot of work!
However, I think that you are seeing that buying individual stocks requires a lot of work. And expertise. You will have to research the company and the industry. And you will have to read the annual reports. Finally, you will have to closely manage your investments.
Maybe this sounds like too much work. You just want to put some money aside for retirement. You don’t want two jobs. In this case, the second method of risk management is for you.
Diversification
Diversification is essentially the opposite of the safety of margin approach. The ultimate returns will be lower but it is much easier to achieve.
So, what do we mean by diversification?
Diversifying your lunch…
Imagine you and your friends decide to go out to eat one Sunday afternoon. You all decide to try something different. One of your friends mentions that a new Chinese restaurant has opened up nearby. He has heard great things about it. So, you all agree to give it a try.
You all arrive and are seated at a table by the hostess. The table is by the window and it’s a nice sunny day outside. The restaurant is situated right by a dock in the middle of the city. From the table you can look out over the water. The sunlight creates diamond like sparkles on the water. The whole scene is very calming.
The waitress brings the menus and you all begin looking through it. After a few minutes you all look up in confusion. The chef is from an obscure region in China and you don’t recognize the food. You’re not even sure where to start.
The waitress comes back and sees your confusion. She has a solution. She tells you all to order from the dim sum menu. It contains lots of small dishes. They are all very reasonable prices. And because there are four of you, you can have a wide variety of food.
There is a chance that one or two dishes won’t agree with you. But if each of you orders four or five dishes the probability that you’ll be able to eat most of it is high. And what you don’t like, somebody else probably will. Thus, the chance that you will waste your money is really low.
So, you all order dim sum. The food is great overall. You tip the waitress a little extra for her sage advice. She smiles and bids you farewell.
So, what the hell does dim sum have to do with investing?
Well in this story you did what? You diversified your lunch! You enhanced your meal and reduced your risk of wasting money. We can do the same with our investments. Research shows, time and time again that by using the principle of diversification you can simultaneously increase your returns and reduce your risk of losing money.
This approach reflects the old adage of don’t put all your eggs in one basket. So instead of investing in one stock, or one real estate property, you invest in as many as possible. You also invest across industries. And across different asset classes. For example, you might invest in stocks, bonds, real estate and commodities. Even a bit of cash as well. You can also invest across different countries.
Tony Robbins recommends diversification!
Tony Robbins talks about this principle in detail in his book Unshakeable. Tony Robbins spent years researching the principles behind investment. He interviewed some of the world’s most successful investors. Investors like John Bogle, Warren Buffett, Paul Tudor Jones, Ray Dalio, Carl Icahn and more. All of these investors agree that if your time and knowledge is limited, following a diversification strategy is ideal.
Why exactly does diversification work?
Let’s start with stocks. When it comes to stocks there are two main types of risk. Market and non-market risk. Market risk is the risk you are most familiar with. When you are concerned about losses with stocks it is because of market risk. This is the risk that the whole market will crash. When this happens, there is a good chance that the stock that you own will go down in price as well.
Non-market risk
Non-market risk is the risk that the particular stock that you buy will go down in price. For example, if a company goes bankrupt then the stock will go to zero. Warren Buffett manages this risk by using the margin of safety approach. But if you don’t know anything at all about the company then you can protect yourself by using diversification.
If you invest in an index fund you can instantly access a diversified portfolio. These index funds track a stock market index. The S&P 500 is a popular market index. It contains 500 stocks (hence the name). It is extraordinarily unlikely that all of these stocks will go bust at once. If you invest in this index you can effectively diversify away non-market risk.
These index funds also provide investments across industries. You can pick a fund that gives you global diversification as well. There are many options and they all help to reduce the risk of losses.
Market Risk
But what about market risk? We all know that the stock market crashes from time to time. Well you can protect yourself from market risk by maintaining a long-term view. For example, during the crisis of 2008, the S&P 500 went down 36%. Seems pretty bad right?
But if you stayed invested for 10 years then your average annual return would be around 10%. And that assumes that you started investing in January of 2008. Right at the peak of the market. In this case you would make back all of your losses. Your total return over 10 years would be 150%.
As long as you can stay in the market long term you will probably be fine. This was, after all, the worst financial crisis in decades.
What if you can’t wait?
But what if you can’t wait 10 years? What then?
Then you need to invest across different asset classes. As I mentioned in a previous article bonds provide good diversification benefits. When stock prices go down, bond prices tend to go up. Bonds are also less volatile than stocks. They go up in price less. But they also go down in price less. And because bonds pay you an income they can be used to create a passive income portfolio.
You can also diversify across industries with bonds. Most large corporations offer corporate bonds. You can diversify across risk classes. If you have a higher risk appetite you can buy high-yield bonds. These bonds have higher returns but also higher risk. It’s a trade-off.
If you have a lower risk appetite you can go for government bonds. US government bonds are among the safest bonds in the world. But this low risk is reflected in lower returns. At times, once you consider inflation, the return on these bonds can be negative. Once again, we have a trade-off. So, in your bond portfolio it may be worth diversifying among different types of bonds. Some bond funds will do this for you so that you don’t have to worry.
Bonds can reduce your risk of losses
But again, the advantage of including bonds alongside stocks in your portfolio is to provide an important diversification benefit. Generally, the low volatility (risk) of bonds will offset the high volatility of stocks. This will again reduce your risk of making losses.
The typical allocation between stocks and bonds is 40% – 60% stocks and 60% – 40% bonds. If you have a longer time horizon you may be able to go closer to 90% or even 100% stocks. But as you near retirement age it may be more prudent to have around 20% stocks and 80% bonds.
What other assets can you use?
Beyond stocks and bonds, you can also consider other assets such as real estate and gold. Real estate prices don’t always move in tandem with stock prices. Plus, real estate has a significant income return (from rent). As such, including real estate in your portfolio can help you diversify.
Secondly, like with stocks and bonds, you can diversify across industries and countries. It is a potent way to reduce your risk of losses. This is especially true today when currently bond and stock prices seem to be moving together.
Gold is an excellent option
Finally, gold. Gold is very accessible. You can buy coins online. Or you can buy portions of gold to be held for you in a vault. Personally, I use Goldmoney. But there are plenty of other options. The point is that gold is not correlated with stocks. It goes up with inflation. Sometimes faster than inflation. If you don’t need access to cash immediately, it can be a great place to put your savings.
Certainly, gold is a preferable to a savings account. In a savings account you will be earning negative interest (according to current inflation rates). And you never know when there will be another banking crisis. On top of that, the gold price outperformed the S&P 500 from December 1999 to July 2017. So maybe a significant allocation to gold in your portfolio makes sense.
Now you understand risk management!
So, there you are. You now understand the key ways that you can manage the risk in your retirement portfolio. In summary:
- We have the following main risk management options:
- Margin of safety
- This makes sense if you want to make a few big investments
- It requires some investment expertise
- You also need time to watch your investment
- It will require more management than diversification
- You will have more control over the investment
- Diversification
- This is ideal if you don’t have any investment expertise
- You benefit from the expertise of fund managers, professional investors, etc.
- You can review once a year or if there are significant changes in your circumstances
- It won’t take you a lot of time to set it up or manage it
- And you can try a combination of the two if you want.
- Margin of safety
There are two ways that you can implement these strategies. You can either do it yourself or hire an advisor to do it for you. If you want to do it yourself, I will be covering implementation strategies in later articles. Or if you can’t wait that long, reach out to me. I’d love to hear from you. But before you do, tell me a little about yourself…
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