In looking for returns on our investments, let’s look at the risk first:
You really lose money ONLY when you have bought something worthless. Or overpaid for a stock, paid Rs.200 for a stock that is worth just Rs.100.
The Philosophy of Value Investing
That is why the philosophy of VALUE INVESTING is focused on paying Rs.50 for an Rs.100 note: i.e., impute a Margin of Safety in the purchase cost of your stocks. So, the REAL management of Risk happens when you are conservative in choosing your stocks. And you don’t overpay for stocks.
You will be amazed that these simple principles are not known to most people: they remain focused on stock prices, ignoring the VALUE of the stock. Which forces them to focus on the short-term, while the company continues to do well over the longer term.
So for every Rs.100 that you invest, it is possible to calculate the POTENTIAL VOLATILITY (called VaR): the amount of money that you might lose ON A GIVEN DAY. This amount is not to be confused with the Real Risk; the probability that you have bought a dud. So FUNDAMENTAL ANALYSIS is the process of understanding the business and buying a real business. And setting a Value to your understanding of the business: this is called Intrinsic Value. We will deal with this subject in a later Note.
Avoiding Risk while Investing
So for every Rs.100 that you put down on the Investment table, let’s say, you’re taking a “risk” (remember: this is actually Volatility, not Risk) of 20-30%. To avoid this, you need to do the following:
- Follow Value Investing as a philosophy, i.e., DO NOT OVERPAY for the stock. In other words, put a secure Margin of Safety to the Intrinsic Value of the stock, say 30-50%.
- Set your expectations of volatility: in bad times, the stock can decline, say up to 20-30%. In rare cases, like the COVID-19 of March 2020, this can go up to 50%. So let’s call this Volatility Risk, to differentiate it from Real Risk. But remember, most people confuse the two.
- Now it gets a little complicated. In the world of derivatives, it is possible to give up some of your upside, to earn Time Value. So if you have Cash lying in the Bank (or as Debt Capacity), you can trade in Puts. Or you have Shares lying in your Demat account, you could trade/sell calls. This earns you 2 different kinds of Income, called Time Value & Intrinsic Value (not to be confused with the Intrinsic Value that you have set on your shares).
When you buy Mutual Funds, you’re just buying and holding the Units (which represent the underlying shares). If the value of the underlying shares goes down, you’re not doing anything about it: in other words, there is NO RISK MANAGEMENT. So that’s why the returns you get can be called “lucky” because you neither made sure of your returns nor do you know how to repeat it the next time. So there’s nothing SUSTAINABLE about the returns you get from Mutual Funds.
By comparison, when you run a Direct Equity portfolio, you can do your own Risk Management, and create SUSTAINABLE RETURNS, with limited downside and maximum upside.
So what have we learned so far?
- That ALL Risk is not real. Real Risk is just a fact, the rest of the FEAR OF RISK is just emotional. We see much more Emotional Fear in markets than real.
- Volatility must be distinguished from Risk. When you learn to conquer your fears, while everyone is fearful, you EARN from Volatility. This is a substantial income, which can be used to reduce your Real Risk.
- Time Value is UNLIMITED, while VaR, or Volatility Risk is limited. At some point in time, the sum total of Time Value that you would have earned (Dehadi, or Derivatives Trading Income) will exceed the POTENTIAL RISK of MTMs that you carry on your portfolio.
- So what you need to learn is RISK MANAGEMENT: the business of earning more from the Derivatives Market than what you are expected to put in. Done carefully, this is many times the Risk you take over the long term.
- STILL TO COME: if Risk is reduced, then you can INCREASE your Investing carefully, using Debt. This increases your Return WITHOUT increasing your Risk. Theoretically, this can be taken to Infinity…….those are the stories you hear in the Media, especially Social Media. They talk about the potential Returns, BUT THEY DON’T MENTION THE RISK THAT MUST BE MANAGED. We will thoroughly understand the Risks, before embarking on any attempt to increase returns.
Come back to this idea again & again, these are timeless concepts. Every time, you will learn something more. We will post these ideas as a Thought For The Day.
