How to measure the risk of a stock market investment the 4 key factors
One of the most important factors when making an investment decision is your risk. Although many savers overlook it, it is not an issue that we should take lightly. Many investors have ended up losing a lot of money because of not devoting the necessary time to analyze the risk assumed in their operations. In this article, we will see how to measure the risk of a stock market investment based on 4 key factors.
The importance of measuring the risk of a stock market investment
With regard to risk, I usually find savers with two extreme positions:
- Those looking for 100% secure investments
- Those who seek to maximize their profitability regardless of risk
In the first case, it is necessary to take into account that no investment is 100% safe. Even hiding your money at home there is the possibility that it burns in a fire or that the moths eat it. Therefore, we should look for a moderate form of risk. In an upcoming article, we will see how to minimize this risk.
On the other hand, there are those who want to maximize their short-term profitability at all costs without having the risk assumed in their investments. If this is your case, I recommend that you be patient and look for long term money with a controlled risk. Otherwise, you most likely end up losing your money in a short time, as is often the case for this type of short-term and unwise investors.
As often happens, virtue is at an intermediate point. We must look for investments that maximize our profitability with an existing but controlled and affordable risk.
How NOT to measure the risk of a stock market investment
There are two very popular ways to measure the risk of a stock market investment. These are:
- The volatility
- The tendency
Despite their popularity, these ways of measuring the risk of an investment make no sense to me or to value investing followers. Let me explain the reasons.
Volatility measures the swing in the price of a financial asset. Modern portfolio theory uses volatility as a measure of the risk of an investment.
Does this make any kind of logical sense? None. This equation between the risk of an investment and the volatility is due to the obsession of the Chicago School of Economics on how to mathematize all economic and financial interaction. It is something that looks nice and elegant in a formula, but it does not make sense from a point of view of logic and financial reality.
The reality is that economics and finance, despite their numerical component, are ultimately based on human action, which goes beyond numbers. Therefore, this way of measuring the risk of an investment has no practical meaning or utility.
The trend measures where the price of a stock has been heading in the near past. When the price is upward, we speak of “uptrend.” On the other hand, when it is a descendant, we speak of “bearish tendency”. According to speculators who embrace this notion of risk, companies with a bearish trend would be much morerisky than those with a bullish trend since, according to them, the trend is usually maintained (although the truth is that it has been shown academically that this type of trend investment It is not profitable under any metric).
As with volatility, this way of measuring the risk of an investment is based on the past price and its movement. Again, this does not make sense from a logical point of view. In fact, for a real investor, if the price of a stock low, the risk will be lower, since we buy the same at a cheaper price.
How to measure the risk of a stock market investment
As we have already seen, the risk in an investment, that is, the risk in value investing, is measured by the possibility of permanent loss of the invested capital.
You have to know that there is no easy and simple way to measure the risk of an investment. You can not measure the risk accurately and millimeter. However, there are cases where it can be seen much more clearly than in others. In Benjamin Graham’s words:
“It is not necessary to know the exact weight of a man to know if he is fat”
However, to give a brief orientation on how to measure the risk of an investment, there are 4 key factors that we must analyze. These are:
- Competitive capacity
- Price paid
The biggest risk when investing in the stock market is us. The main problem that investors have in Spain is investing without the necessary capacity to do so. This poses a great risk to your investments for 2 reasons.
On the one hand, for lack of temperament. To win in the bag is necessary to go against the pack. As Buffett would say:
“Be fearful when others are greedy and be avaricious when others are fearful.”
This, which is said soon, is not as easy as it seems.
On the other hand, there is the problem of lack of training. If you want to invest in the stock market you will need to invest first time and money in training. I’ll let you know that it’s not easy to learn in a couple of hours. Of course, I also assure you that it is worth it. If you want a first class training, I encourage you to take a look at some Investors Club where you will learn to invest in stock market, step by step and from scratch (take the opportunity, since you have a big discount and my total guarantee of satisfaction).
It is also important to invest companies that we are able to understand. For this, it is necessary to assume our competencies and our weaknesses. For example, I tend to avoid sectors like banking, insurance or biotechnology, because they are too complex a sector to value for people who do not know them in depth.
Already within the analysis of the company itself, the first thing we must look to analyze to determine a company’s risk is its financial health. The basis of the analysis of financial health is the study of liquidity and solvency ratios and debt ratios.
A big business can end up biting the dust because of excessive debt. This is usually seen in cyclical or little stable businesses that have not been able to prepare for times of crisis during times of abundance. It is precisely what we are living today in companies of some sectors such as energy or mining.
The second key factor that we must analyze is the ability of the company to compete profitably in the market. For this, we must perform a complete competitive analysis.
To determine the competitive capacity of a company we can start with an analysis of the sector. It is often more interesting to invest in companies that compete in stable sectors, even boring ones, than in those that trade in sectors whose future is difficult to predict.
It is also important to look for companies with sustainable competitive advantages, whatever their sector. Their presence will enable them to maintain their profitability and their long-term competitiveness.
This is a very brief summary of what we should analyze. Personally, I analyze about 150 pointsbefore investing in a company.
Is it excessive? Can be
The price paid
Finally, you have to be clear that, no matter how good a business, it will only be an interesting investment if we buy it at a good price.
Therefore, having adequate safety margin will be essential when selecting our investments. Adequate training will also be necessary to allow us to analyze investments to calculate their intrinsic value as accurately as possible.
In short, how do we know if an investment is risky?
Debt, competitive capacity and price paid are key factors to analyze to determine the risk of an investment. This is the starting point, but we need to go further if we want to determine the real risk of a company. The key will be to perform a good financial analysis and, above all, a deep competitive analysis that allows us to know the company thoroughly.
As you can see, there are no shortcuts, although many will try to convince you otherwise. If you are interested in learning to analyze companies thoroughly to invest in the most profitable and safe way in the long term, I encourage you to join the Investors Clubs, with all training step by step to learn to invest in stock market and analyze investors as a professional.
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