Risk – How to deal with it?

When you invest money, risk is always inherent. For many small investors, the question of risk, i.e the risk of losing money, is of great importance. Especially, because they invest their hard earned money. So today, we want to look a bit closer to risk.

(Watch the risk post as video!)

For many people, investments are a very sensitive issue. It’s interesting that it’s a topic in which they have a completely different risk assessment than in other things. Losing money is a fearful thought for many. Because of this fear, they estimate the danger of losing money with investments more than it is actually appropriate.

On the other hand, many people are willing to take unreasonably high risks in different life situations. They are willing to jump of a bridge with only a rope at their feet. They drive at an incredible speed across the country during a rally. Others jump from roof to roof or make picture at the top of skyscrapers or cranes.

It is not that those people are unaware of the danger involved. They only estimate it differently. A possible loss is perceived, but regarded as very unlikely or maybe acceptable. It is interesting that losing money is assessed higher than losing life or getting seriously injured. 

The greater the potential for reward in the value portfolio, the less risk there is. (Warren Buffett)

Successful investing is about managing risk, not avoiding it. (Benjamin Graham)

Losing money is worse than losing life

Many small investors are so afraid of losing their hard-earned money that they don’t like to invest it. I know that it depends on the country you’re from. Many Germans, for example, don’t trust the stock market. According to an article in the Handelsblatt from February 2018, around 10 million people in Germany invest in stocks and funds, which is approximately 12%, while more than 50% of Americans own stocks according to a Gallup poll. 

When I try to talk about the stock market, many Germans won’t listen. They think, the stock market is a casino where greedy speculators ripp them off. That’s why so many don’t even think about investing in shares and lose money investing in the wrong assets, like low interest treasury bonds or saving accounts. 

But is this fear justified?

Well, the risk of losing money while investing is real and it is a legitimate and important question that must be considered. But to fear a loss so much that you resist investing your money and therefore don’t get interest and compound interest, is absolutely not justified. 

The problem behind that behavior is a psychological one. Most people perceive a small loss more than a great win. So the adjustment between win and loss and chance and risk is what has to be changed. But that’s a difficult task, because people are just like they are and talking is easier than doing. 

So there are two questions that need an answer: 

How can we deal with our psychology? 

and

How can we learn to handle the risk?

You don’t always see that you are losing money

I think, risk can be viewed in two ways. On the one hand, there is the risk of not managing your own money sensibly and profitably. This is the risk of missed opportunities. In my eyes, the risk of following the herd. The risk of marginal returns due to low-interest investments.

Managing your money that way leads exactly to what the average investor mostly fears: He all too often loses money! And it may even be that he loses it without actually perceiving it.

Let’s take a very simple example:

Let’s assume, you invest $1,000 at 1% return every year. The annual inflation rate is 2%. So, at the end of the first year you get $10 interest. But the purchasing power of your $1,000 decreased by $20 because of inflation. Although you have $1010 on your account at the end of the year, your actual assets are $990, taking the purchasing power into account. You have actually lost money, even though you have your money safely on your savings account or in treasury bonds.

The risk of investing

The second way of looking at risk is the actual loss of your invested capital when an investment performs poorly. This is the risk you have to face when investing and it’s the risk you have to deal with when you want to build your fortune over the long run. 

Your task as an investor is not only to deal with this sort of risk, but to keep it as low as possible while increasing your return as much as possible. That’s what value investors try to do. And although many believe that you can only get higher returns when risk gets higher, this assumption isn’t always true. It mostly depends on your strategy and what you pay for your investments.

Risk Free investments 

We have to note that you can lose money with almost every asset class. It is an illusion to assume that there are risk free investments although there are investments that are nearly risk free, because a loss is very unlikely, such as long term treasury bonds of high developed countries like the U.S. or Germany. But these supposedly safest states could also be able to no longer serve their bonds. 

In the end, it is merely a question of whether we want to see the risk – which we often do not want to – and how high it is, which means, how likely is the occurrence of a loss.

Real estate

Real estate can lose significantly in value as we have seen in the crisis of 2008, when hardly no one wanted to buy a home, but many were forced to sell. At these times it didn’t help that you had real value like the house and the ground on which the house stands. The market just didn’t want to pay for the value he could get. And that was and always will be terrible. But only if you have to sell. So, the risk lied in the need of selling, not in the asset, although many houses had been bought too expensive. If you could hold the property and use it at a home, you have no risk of loss.

But you can also have bought real estate at a price much too high – as I just mentioned – and you will never get your money back when you want to sell it, just because the market tends to pay for the real value over the long run, not for psychology of people. So, even with real estate, paying too much is a risky game.

Gold

Gold is strongly dependent on the economic assessment of people. The value of gold is based upon the psychology of the people and on the cost and quantity of mining. Unfortunately, Gold doesn’t produce any value by itself. But the greatest problem of gold is that you don’t know if you are at the beginning of a boom or at the very end. That’s why the risk of failure is very high and ends in losses much to often.

These are just two examples with a different risk of loss. A loss may occur, but doesn’t have to. As an investor you have to assess the probability of a loss and to make arrangements that minimize the risk and largely reduce the occurrence of any loss. For the remaining risk, we expect either a better price or a higher yield.

Minimizing risk

I myself focus on stock investing. So, the question is, what can I do to minimize the risk of a loss when purchasing shares?

One of the essential element is my long-term goal. When I buy stocks of a company, it is my goal to keep them at least 10 or more years. Like Warren Buffett, I love to find companies that I want to own for a lifetime. That’s because of two main reasons. Shares are the most successful investment class at all and the risk of loss decreases the longer you hold them provided that the company remains outstanding.

Nevertheless, this is absolutely not enough. I have to consider other criteria before making a decision on purchasing shares. These criteria help me to assess the risk in advance and keep it as low as possible.

Criteria

One possibility of lowering the risk of losing your investment is not buying any stock that is recommended to you by anyone and if you don’t buy everyone’s darling. You lower your risk, if you only buy when the stock meets all the criteria that you set for a good or outstanding company. Such criteria could be to only buy companies within you circle of competence. The more you know and understand about a company the better your decision and the lower the risk of loss.

Another criterion could be to always buy with a reasonable margin of safety. Because a lot of your investment success depends on how you’re buying. If you buy companies at a high price, this investment could be very risky. How high is the probability that an overpriced stock could get much more overpriced? And risk is always a part of probabilities. However, buying at a reasonable price with a margin of safety to intrinsic value reduces the risk of a loss and increases the probability of a profit.