What is risk in investing?
The Anatomy of Risk And How To Avoid The Permanent Trap
“You must know your risk appetite before investing.”
“Markets are risky and can crash 30%. Invest later.”
“I am a risk-averse investor.”
“I can’t take risk with my money. This stock can fall 20%!”
“Investing is risky. And I don’t have the risk-taking ability.”
These are some common advices we hear from investors and financial advisors over and over again, and especially when stocks prices are in a correction mode.
Everyone talks about ‘risk’ when it comes to investing in stock markets. But ask them what ‘risk’ really means, and they will be clueless. Risk isn’t just a number. Like a 30% fall in the stock markets, or a 20% fall in your favourite stock.
What does ‘risk’ really mean?
As per Warren Buffett, the risk of holding any investment is only the ‘permanent loss of capital’. For example, if a company goes bankrupt, or its earnings power drops permanently, then shareholder value will also become permanently diminished.
Stock markets falling and your stock prices coming down with the fall isn’t ‘risk’, simply because such a fall is not permanent if you own good quality companies in your portfolio.
How to avoid permanent loss of capital?
Here are two simple rules that can save you from the pain of seeing your savings lost permanently.
1: Know what you are getting into
You need to understand the business or mutual fund that you are buying. Investing (or speculating) on a free tip you’ve received from someone else is a sure shot way to lose it all as you will never know what you were getting into.
So, do your homework before investing in a stock and buy only when you are convinced that the company isn’t going to go down the drain in the future.
Remember, the risk always comes from not knowing what you are doing, in life and in stock market investing.
2: Avoid borrowing to invest.
When you are borrowing money, it comes with the cost in the form of interest. In an instance when you permanently lose the capital, you are liable to give back whole capital along with the interest and interest on interest (debt trap) when you need time to repay.
Warren Buffett says, “Risk comes from not knowing what you are doing.” Because when you don’t know what you are doing, you can lose it all…permanently.