MITIGATING DOWNSIDE RISK THROUGH VALUE INVESTING
Any type of investment will always be associated with inherent risks one way or another due to uncertainty. Investors who prefer low downside risk may seriously consider value investing as one of the approach to achieve their investment goals. This is mainly because this approach is not only very prudent in practice but it also will reward its followers handsomely, provided they are strictly guided by its sound principles and its best practices.
To have a clear framework on how it works, we need to fully understand what is meant by downside risk and how it works to preserve its investment value.
DEFINITION OF 'DOWNSIDE RISK'
“Downside Risk” is an estimation of a security's potential to suffer a decline in value if the market conditions change, or the amount of loss that could be sustained as a result of the decline. Downside risk explains a "worst case" scenario for an investment, or how much the investor stands to lose. Some investments have a finite amount of downside risk, while others have infinite risk. The purchase of a stock, for example, has a finite amount of downside risk; the investor can lose his or her entire investment. The sale of a stock, however, as accomplished through a short sale (or "selling short") entails unlimited downside risk, since the price of the security could continue rising indefinitely.
CONSERVATIVE YET HOLISTIC APPROACH
Value investing, by its nature, has taken all measures in establishing all possible downside risks. That’s the main reason Graham proposed the margin of safety in the first place when acquiring shares below its intrinsic value. This margin of safety can be scientifically computed based on those factors which may have adverse effect on its intrinsic value such as human error. Moreover, you are buying at your objectively clear criteria without reference to market. This is the whole idea of investing; that you are not led and dictated by the market, but the market becomes your slave instead of your master, in making handsome profits.
As a result, value investing demands analysis of both quantitative and qualitative approaches while mindful that past performance cannot guarantee future performance. What matters most are both the leading financial and operational indicators. Looking beyond financial statements objectively will enhance your understanding of a firm’s operational, financial and strategic plans and help ascertain whether company is building its core competencies to sustain its business growth and profitability. Companies that achieve a high return on capital are likely to have a special advantage that keeps their competitors from destroying their ability to earn above-average profits.
Thus you are able to ascertain with much certainty whether you are buying good businesses that can truly enhance your investment. This is in line with Buffet's two golden rules; not to lose money and obey the first rule at all times. On the flip side, it is also preserves your capital in the sense that the stock you invested in has more relative stability of assets, if you have done your homework well especially if you use the worst case scenario of liquidation valuing method in establishing your intrinsic value.
DOWNSIDE RISK IS LIMITED
For the above reasons, we believe that the downside risk is limited. This is because we attempt to defend against significant losses while seeking reasonable returns. That's how our strategy was initially created and crafted for. While it is tempting to try to capture all of the upside of a bull market, being caught in the potential downside will result in holding the stock for a longer term. Thus, these two approaches are much more thoughtful and preferable in view of much higher possibility in reaping its profit.
Once you are clear of your investment’s purpose, you will tend to play your game with more focus on the process that delivers your end result, rather than chasing hot stock without any clue like many investors do. By eliminating your emotion and temptation, you will tend to have better control of yourself and your game. Being disciplined and being more patient will become your investing character. You will tend to follow your roadmap in picking your stocks that meet your criteria. You are able to be wired for making prudent investment decisions. To manage our investment well, we need to make sound decisions and to implement them efficiently.
Managing by results is mechanistic. Management for results and by the right process is a better choice. Managing by results only focuses on the returns of our investment. No specific primary attention is given to the means of achieving the ultimate goals. Value investing is more inclined to the process of investing, which forms the key to success.
To hit the bull’s eye, you must align the sights of your gun with the target. The sights are the means by you hit the target. You must focus on the sights and accept the relative haziness of the target. Rewire your mind to focus on the results you want to achieve, or focus on the process of buying stocks which are in line with your direction toward your goals. Quality decisions are the way that leads to achieving your ultimate goals, provided they are effectively implemented.
We should leave nothing to chance when it comes to crafting and implementing a high-quality investment programme that delivers predictable earnings and dividends. To ensure that you reap the fruits fully, the right thing must be done at right time, in the right order, at the right intensity, and in the right sequence. You must do things right, rather than just do the right things.
The drive must come from the ultimate purpose we intend to achieve. By then it will keep us directing our energy and efforts in complying with the process with ease. The profits come from the opportunity. The process must be able to direct us to focus on identifying the opportunity. Thereafter, it enables the investor to realise his investment once the stock price hits its intrinsic value and above. It sets a very clear framework for every entry and exit point of its investment. However, it gives some room for the investor to set his own investment portfolio based on his available fund. The result is less important to the entire process. Therefore, this systematic approach does not leave the entire investment to chance, but rather is guided by profound and sound proven principles and best practices. Ultimately, it is closely associated with shaping the investor with appropriate required investment skill and behaviour that generates consistent and persistent profits. In other words, sounds decisions, with efficient implementation will lead to sound investment behaviour. That behaviour makes the significant difference. This behaviour will not be influenced by the daily fluctuation of the stock. These repeated processes delivers the ultimate results and not by chance.