In article #4 we have learnt that one of the ways of performing the investment operation is to use the idea of expected value. Firstly, we need to value the business of the company; secondly, we need to find out the expected value of the return that we can get by purchasing the stock at the prevailing market price. When we do this for many stocks, we can choose those stocks which are expected to give the best return according to our desired rate. [Deep down, we are using the concept of Probability and Opportunity cost.]

The above method when performed for the very long term can provide very good long-term return to the investor, even can beat the broader market index by a wide margin. But where can we go wrong in doing this? In other words, let us try to define risk in our investment operation. [Using the concept of Inversion.]

The risk for an investor is either the permanent loss of capital or not being able to generate adequate returns over the long term. This risk can manifest by following ways.

The risk associated with the business itself.

There are various kinds of businesses. As an owner of the business, we are particularly interest in the Return on Capital that the business is generating. It is generally said that the business which is generating return on capital greater than the cost of its capital (including equity capital), and is growing without the use of externally borrowed money is a good quality business.

So, some of the risk associated with the business itself are the dependency on the capital market to fund the growth, and very high competition not letting to generate adequate return on capital. There are many more risks associated with the business which we shall learn as we move further.

Thus, sticking with the high quality businesses reduces the risk of permanent loss of capital for an investor.

The risk in valuing the business.

Another risk can come from lack of understanding of the business to value it properly. Understanding of the sources of revenue of the business and business cycle among other things are critical to evaluate the fluctuations in the profitability to value the business.

Although, valuing is not very definite i.e. it is a very rough estimate to make. But, the huge error in this number can inflate the error in estimating the expected value of return from the purchase of its stock.

Here again, Benjamin Graham proposes to use the margin of safety concept. Buy the stock when the price is substantially below the estimated value of the business. David Dreman, an investment manager and author of the book “Contrarian Investment Strategies”, suggests buying the stocks when they are beaten down or out of market favor. He uses several ideas from Psychology like Affect and Cognitive Heuristics to show that the market participants often overreact in the market which takes the prices of good quality stocks to unbelievably low level. He also showed several studies that confirm the use of strategies like low price to earnings, low price to cash flows, low price to book value, high dividend yield, or combination of them have generated market beating returns over the long term.

Thus, purchasing the stocks at the price which is substantially below their value reduces the risk of error in estimation of an investor. Investor doesn’t need to forecast the earnings of every quarter of the business.

The risk of over-concentration in portfolio

Another risk comes from our over-confidence in any business or investment securities. It can be due to our likeness towards them or any other biases. It can cause us to allocate significant capital of our portfolio to single asset. The black swan like events which we are not aware of, or which has not occurred in the past can completely ruin that investment. It can permanently ruin our capital.

Again, the deeper understanding of business, risks associated with it can help greatly in allocation the portion of the portfolio. For someone with limited understanding of the businesses, diversification helps. For someone with very good knowledge of all the aspects of the businesses, concentrated portfolio can work.

Mr. Charlie Munger said that the portfolio of three stocks is sufficiently diversified when it has high long-term expectancy of beating the market returns without any catastrophe in any single year. The only thing requires is to have deep understanding of those businesses.

The risk of leverage in portfolio

Leverage in our investment operations or in investee companies- both are risk in the operation. Leverage is very difficult to handle. It is true that the leveraged portfolio can generate substantially more return than the unleveraged one. But at the same time, it can be disastrous.

Remember, to win the race first, it is critical to finish it. In order to get the market beating returns in the long run, it is important to not to get out of business in between.

Other than the above risks, there are several more risks like illiquidity in the market, the need of funds in between our investment periods etc.

Let us conclude this discussion by jotting down the few simple and big ideas that we have learned.
1. Invert. It’s often useful to invert the problem and find the solution.
2. In investing, it’s better to play a loser’s game. Instead of forecasting the earnings estimate, purchase businesses when they are out of favor.
3. Develop circle of competence to know everything within its circumference.
4. Think in terms of numbers and probabilities.

Disclaimer: The above learnings are from the book Contrarian Investment Strategies by David Dreman. We try to apply these learnings to our investment operation. We can be wrong in our thinking or that our thinking can change in the future as we learn more. So, let's move forward with a sense of skepticism.