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The Importance of Education and Research in Risk Management

Investing in the stock market can be a lucrative way to grow your wealth, but it's not without risks

To be a successful investor, one must learn to manage these risks effectively. In this blog post, we will explore risk management, which is a major pillar in Andy Tanner’s teachings on stock investing.

We’ll start by stating that financial education and extensive research form the foundation of successful investing and effective risk management. Nothing substitutes having a deep understanding of financial markets, investment products, and economic trends.

As Andy points out, research allows you to look into a company's financial health, competitiveness, industry position, and potential risks. It involves analyzing various parameters, such as earnings reports, balance sheets, cash flow statements, and market trends.

The objective of such research is not only to identify lucrative investment opportunities but also to understand the potential risks that come with each investment. By having a comprehensive understanding of the investment, investors can anticipate potential market or company-specific disruptions and devise strategies to mitigate those risks.

Two types of risk

There are two basic types of risk when it comes to stock investing: non-systemic risk and systemic risk. In order to effectively manage your risk, you have to understand each type of risk…and you have to have strategies in place to mitigate each type of risk.

Non-systemic risk is risk that is limited to a certain company. For instance, a major oil spill like the 1989 Exxon Valdez oil spill had a major impact on Exxon’s stock, but it didn’t present a risk to the oil and energy sector as a whole. If you were invested in Exxon at the time and didn’t have risk mitigation in place, you could have lost your shorts, but someone who was invested in Shell, for instance, would be just fine.

Systemic risk, as you might guess, is risk that can impact an entire sector or even the market as a whole. A great example of this was the 2008 subprime mortgage crisis. It tanked both the housing market and the economy as a whole. In a systemic risk scenario, every investor is at risk and needs a good plan in place to manage that risk.

Let’s talk about diversification

Diversification, the practice of spreading investments across various types of assets or asset classes to reduce exposure to any single asset or risk, is a commonly recommended strategy for risk management. The principle behind diversification is that a variety of investments will, on average, yield higher returns and pose a lower risk than any individual investment.

This isn’t always the case, however. Diversification only primarily addresses non-systemic risk, the risks specific to a company or industry. By investing in a wide array of companies and sectors, the impact of one company's failure is minimized.

However, diversification does not protect investors from systemic risk—these are risks that affect the entire market, such as inflation, political instability, changes in tax policy, or an economic recession like the 2008 housing crisis. Systemic risks are unavoidable and can only be managed, not eliminated.

Andy Tanner refers to diversification as simply a flu shot. A flu shot is great at preventing the flu, but it doesn’t help you with heart disease, diabetes, and cancer. It’s for one scenario. So is diversification. It can help with certain types of investment strategies, but it is not protection against systemic risk.

So at Rich Dad, we don’t give conventional advice and leave you to your own devices. We like to give you a bigger picture. So instead of relying just on diversification, a proper risk management strategy should include the use of options, setting stop-loss orders that automatically sell an asset when it reaches a certain price, or hedging with other types of investments such as bonds or real estate—all things we’ll need to get into in other posts. These methods provide additional safeguards and enable a more robust response to market changes.

Manage your emotions when it comes to stock risk management

Emotions can have a significant impact on the investment decision-making process. Fear and greed are particularly potent and can lead to irrational investment decisions. During a market downturn, fear can drive investors to sell their holdings at a loss, while greed can encourage over-investment during market upswings, potentially leading to significant losses when the market corrects.

If you want to be a successful stock investor, you need to manage your emotions and stick to a disciplined investment strategy and stick to it, regardless of market fluctuations. This involves setting clear investment goals, establishing risk tolerance levels, and creating a balanced investment portfolio that aligns with these goals and risk tolerance.

For instance, it’s important to have thresholds set ahead of time on when you’ll sell a stock and your acceptable threshold level of risk. You can use a simple strategy like a reward risk ratio, which is simply the amount you want to earn for every dollar invested, to set your risk threshold before you invest.

You can also automatically set a stop loss order for a certain price point, so that if a stock drops to a certain price, say below your risk reward ratio, you can automatically sell. Many people get too emotionally invested, hanging on when they know they should sell, hoping things will go up. You have to get rid of that and automate that decision ahead of time. As they say, “Hope is not a strategy.”

Emotion-driven decisions often lead to a 'buy high, sell low' pattern, which is the opposite of the desired 'buy low, sell high' investment strategy. To counteract this, it's crucial to have an investment plan in place and stick to it, rather than react to market volatility.

Don’t let bias get in the way and be as objective as a stock investor as possible

We all have biases, and they get in the way of good investment decisions. In this case you are your own risk!

For example, confirmation bias can cause investors to seek out information that confirms their existing beliefs while ignoring contradictory information. This can lead to an overly optimistic assessment of an investment opportunity and potentially result in significant losses.

Robert always cautions you not to follow the herd. Why? Because the herd is often being led to slaughter! Herd mentality is a bias where investors follow what others are doing rather than making independent decisions based on their research. The result is almost always getting slaughtered. By the time the herd moves in, the smart money is already moving out.

Again, nothing replaces doing your own research, challenging your assumptions, and seeking a diverse range of opinions. You also need to regularly review and adjust your investment strategy based on changes in market conditions and personal circumstances.

Examples of risk management in non-systemic and systemic scenarios

Examining real-world examples can offer valuable insights into effective risk management strategies. Let's consider two major events: the 1989 Exxon Valdez oil spill, which represents a non-systemic risk, and the 2008 housing crisis, which illustrates a systemic risk.

In the case of the Exxon Valdez oil spill, Exxon Mobil faced one of the most significant non-systemic risks a company can encounter. The accident led to a significant drop in the company's stock price due to the financial burdens of the cleanup process, legal liabilities, and damage to the company's reputation. However, investors who thoroughly researched Exxon's financial strength and industry position realized that despite the significant setback, the company had the resilience to recover. Those who held onto their shares or seized the opportunity to buy during the dip were rewarded when the company's stock price rebounded.

Conversely, the 2008 housing crisis was a systemic risk that affected the entire financial market. The housing bubble, driven by loose lending practices, overvaluation of assets, and complex financial products, led to a severe financial meltdown. However, certain investors, like John Paulson, recognized the looming risk. Paulson, having researched the market extensively, shorted the housing market and turned this systemic risk into a massive profit-making opportunity. He certainly wasn’t following the herd on that one!

Defend your chart!

Andy Tanner has a simple mantra when it comes to risk management: Defend your chart!

Risk management involves not only understanding and anticipating risks but also developing strategies to protect your investments when these risks materialize. This is where the concept of defending your chart comes into play.

You should be ever-vigilant and prepared for sudden changes in the market and have a plan for each potential outcome. This means developing an investment strategy flexible enough to adjust based on market fluctuations.

One practical approach is to pay close attention to market trends. This involves technical analysis, where investors study past market data, primarily price and volume, to predict future price movements. For example, if the trend is upwards, an investor may consider going long, buying stocks in anticipation of a price rise. Conversely, if the trend is downward, they might consider going short, selling borrowed stocks with the expectation of buying them back at a lower price.

Moreover, using options can be an effective way to defend your chart. Options allow investors to hedge their bets by buying or selling the right to buy or sell a stock at a specific price within a certain period. By employing options, investors can limit potential losses if the market moves against their predictions, providing an additional layer of protection against unpredictable market movements.

Risk management is a complex and dynamic aspect of investing. It requires ongoing education, extensive research, a keen understanding of market trends, and the discipline to adhere to your investment strategy. It necessitates acknowledging and managing the impact of emotions and biases on decision-making, utilizing strategies such as defending your chart and diversification, and taking advantage of technological advancements.

Historical events like the Exxon Valdez oil spill and the 2008 housing crisis underscore the real-world implications of both non-systemic and systemic risks, and the importance of effective risk management strategies.

By following the principles discussed in this post, you can navigate the investment landscape more confidently, manage risks effectively, and keep their financial goals well within reach.