4 Methods for Mitigating the Risk of Investing

‘Bro, do you invest in stocks?’

‘No man, it is too risky for me to invest in stocks.’

Stock investing, like any other approved and legitimate investment is not without risk.

For some (if not most of us), the word ‘Risk’ carries a negative meaning. Hence, there is a tendency to dismiss stock investing as ‘too risky’ a method for building wealth. On the other hand, savvy investors know that risk management plays a big role in attaining continual long-term success in stock investing.

Here, we would like to share 4 general methods that savvy investors use to mitigate the risk of investing in stocks.

#1: Income Certainty

Savvy investors are risk-averse by nature. Instead of being overly concerned with market volatility, savvy investors are more comfortable focusing on the stability and expandability of a stock’s income over the long-term.

To achieve this, they first want to know whether a stock has a track record of generating profits in the past. This involves assessing the financials of a stock.

Secondly, they want to know whether the stock would be able to continue generating profits in the future. This involves reading the company’s Chairman’s and CEO’s statements as well as the Management’s Discussion & Analysis. For instance:

• For REITs, they would try to find out if the company will continue to derive rental income from existing tenants and whether it has plans to acquire new investment properties in the future.
• For property stocks, they would try to find out the total Gross Development Value (GDV) of the company’s on-going and future property development projects to be carried over the next few years.
• For manufacturing stocks, they would try to find out whether the company has plans to add new production lines or to build new factories in the future.

This means that savvy investors would always want to know how the money is being utilised by the management before acquiring the company’s shares.

#2: The Trend is Your Friend

Basically, savvy investors tend to pay more attention to 2 types of trends. They are:

1. Industry Trends

This information is usually presented in a company’s Chairman’s and CEO’s statement. For example:

‘Global demand is estimated to be at 180 Billion pieces per annum for 2015 and is expected to continue growing by an average of 5% to 6% every year’.

Extracted from the Annual Report 2015 of a Rubber Glove Manufacturing Company

‘Our Primary Client, X, has recently indicated that they intend to reduce as much as RM 50 Billion from the capital and operating expenditure budgets of RM 350 Billion over the next 4 years.

Extracted from the Annual Report 2015 of an investment holding company

Instead of speculating, savvy investors always make investment decisions based on publicly available information obtained from approved, reliable and legitimate sources. This is why reading documents such as Annual Reports helps savvy investors to find out and understand industry trends.

2. Share Price Trends

This involves interpreting stock price charts. Instead of speculating, savvy investors would identify share price trends to determine whether the investment capital is flowing in or flowing out of a stock. By identifying price trends, savvy investors aim to profit when the share price is going up and preserve their capital when the share price is going down.

#3: Set Contingency Plans

Every savvy investor knows that they can never avoid making an investment mistake. Thus, the objective is to ensure that you do not suffer from huge financial losses from one bad mistake. This involves preparing a well-thought out contingency plan in advance to insure against investment risk. To name a few,

1. Stop-Loss Order

Savvy investors would place a stop-loss order to preserve their investment capital in the event of a continual drop in share prices.

2. Establish a Good Margin of Safety

This technique is widely practised by value investors. For example, value investors would first calculate the intrinsic value of a stock. Let us assume that the intrinsic value of ABC Bhd is worth RM 1 a share. Next, a value investor may purchase shares of ABC Bhd if its stock price is trading at RM 0.70 a share. This is because it gives a good margin of safety of 30% from its intrinsic value.

3. Diversifying

Imagine you have RM 100,000 to invest in stocks. Would you invest RM 100,000 in one single stock? Most likely, savvy investors would spread their investment capital into a number of stocks. As a result, poor performance of one stock is mitigated by the potentially good performance of other stocks in your portfolio.

#4: Continuous Learning & Improvement

In the world of stock investing, nobody claims to know it all. Thus, savvy investors are always committed to spending time, effort and money to learn and improve their investment strategies.

If you are willing to learn, you can start by attending classes, lessons or seminars on the subject of investing. In general, various sources of information are available through online materials, books, workshops and more.

This article is sponsored by Securities Commission Malaysia, under its InvestSmart initiative.

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