Abstract: Explain the importance of risk management for investment and why risk management must be pursued in order to achieve long-term investment success. The two most important ways are to avoid excessive borrowing of investment and appropriate diversification of investment.
Investment is for long-term
If you want to invest successfully, you must focus on long-term development, not short-term results. For instance, if you make a big profit of 20% this year, but lose 15% in the next year, it is difficult to be successful in investment if your investment result is highly volatile for a long time. Therefore, the investment risks must be controlled as much as possible. Of course, risks cannot be completely avoided, such as market systemic risks caused by macro factors such as wars and changes in interest rates. Unless you are a prophet, or you never invest, or you just keep 100% cash for a long time, of course, holding cash for a long time will create other problems. I have some high-income friends who really never invest and are not unwilling to take any risks. Among them are doctors, civil servants and some who do business. Anyway, they think they have a stable high income, so there is no need to take risks to invest.
Two basic methods of risk management
I think the two most effective ways to control risk are actually very simple, namely:
- Don’t borrow money to invest
- Properly diversify your investment.
Don’t borrow money to invest
First of all, you should avoid borrowing money to invest as much as possible, or if you really feel that there is a once-in-a-lifetime chance and are very confident and so you think you have to borrow money to invest, in this case I suggest you should not borrow more than 10%-15% of the total asset value; and you should really prepare for the worst at any time. More importantly, you should be able to repay the loan at any time in a short period of time. Since the loan ratio is within 15%, even if you encounter significant market drop, the chance of margin call or liquidation is not very high, but as a responsible investor, you must always book the worst-case scenario so that it can be foolproof.
As you may see in my “Long-term growth stock portfolio”, I have invested on margin which currently accounts for about 12% of the total portfolio value. Please note that I am not encouraging anyone to borrow money for investment. You must be aware of the potential risks that borrowing money for investment can bring you. If you are not careful, you can really lose everything overnight. Here I would like to tell you the reasons why I borrowed money to invest, as follows:
- At present, my loan interest rate is about 1.6%, which is really a rare and extremely low interest rate, and so is very attractive.
- I can repay the loan at any time and so it will not affect my life. If the interest rate rises to the normal level in the future, I may pay off the loan immediately.
Another way to effectively manage risk is diversification. I believe many people have already understood the importance of diversification. Here I want to emphasize some of my points. First of all, the more diversified the investment, the lower the risk, but the return will also be affected negatively. You must remember this truth clearly. As I mentioned in my previous article “Two basic investment logic – Capital gain vs Fixed income”, you must first understand what kind of return you are looking for before making an investment decision. Do you want capital gain? Or stable fixed income? Please don’t think that you can have both.
As can be seen from the figure below, the more different types of stocks you hold, the more you can diversify the risk, but the risk will not be diversified endlessly. Calculated based on statistical probability, when the number of shares reaches 15 to 20, then further increasing the number of shares is not likely to further reduce the risk, as shown in the figure below.
For those who pursue capital gain
If you want to pursue capital gain, you should appropriately control risks. It is necessary to diversify investment, but not too diversified, otherwise you will only get mediocre returns, and it will be difficult to achieve the obvious effect of long-term capital gain. My suggestion is that if you want to pursue higher growth or returns, the investment portfolio should be controlled within 15 investment targets at most. Of course, if you have sufficient confidence and awareness of your investment, you may control it within 10 and then the result will be even better.
In the famous book – Common Stocks and Uncommon Profits, the author Philip Fisher suggested that the number of stock investment should be concentrated in 4 to 6, Fisher believes that this can guarantee a relatively high long-term investment return. So how many stocks should we invest in? The answer is actually varied from person to person, because it all depends on how well you understand the target you are investing in. The more you understand the company, the more confident you will be in the company’s long-term success; at the same time of course the risk you will face will be relatively lower. This is why Philip Fisher has always emphasized in the book that he only concentrates on investing in a small number of companies, because he had an extremely in-depth understanding of the operating conditions of these companies before making any investment decisions.
For those who pursue fixed income
If you only want to pursue stable fixed-income returns, I think the more you hold different companies or different types of investments, the better, even more than 20 is okay. I don’t think it’s a problem. Such a diversified investment will unavoidably get a mediocre return, however, since this is something you have anticipated – that is you won’t expect a certain company to suddenly release a new product or issue a profit forecast. Even if these happen, the overall return will not be lifted very much; conversely, the overall return will not be pulled down very much because of any unexpected events or even some black swan events in a certain holding in your portfolio. You can safely receive bond coupons, dividends, rent collection or Reit cash distributions on a regular basis. You don’t have to pay attention to economic news every day. You can do whatever you like, just stay away from stock market news, and feel at ease at night and sleep well. This is actually quite good. I dare say that if you insist on doing this, your returns can even outperform many speculators who follow the stock market news every day but don’t actually know what stocks they are buying.
Comments and sharing
I am going to finish it here. If you have any questions, please feel free to leave a message or comment below, I will reply you. Or if you find anything incorrect in the article, please let me know and learn from you. If you find it interesting or it may help you in any sense, please share with other people.