How to Manage Your Downside Risk - No BS Investing
Posted 212 views June 1, 2022, 13:00 - Elisabeth in Investing

How to Manage Your Downside Risk

Downside risk is the risk that the money you think you’ll earn from your investment will be lower than what you expect. It’s the risk of losing money. 

Luckily, there are ways to reduce downside risk as a value investor. Check out the following steps to lower your downside risk and the probability of losing money. 

Key Takeaways:

  • Diversify your investments. For value investing, diversification is where you invest in different types of companies and industries to create a healthy portfolio and lower your risk. 
  • Calculate your margin of safety. Margin of safety is the difference between a company’s current share price and its intrinsic value. This gives you a buffer to make mistakes and still make money. 
  • Average-down your purchase price. This means that you purchase more of a stock you already own after that stock has decreased in price. By doing this, you lower your average purchase price.

1.  Diversify your investments.

Ever heard the saying, “Don’t put all your eggs in one basket?” That’s what it means to diversify. For value investing, diversification is where you invest in different types of companies and industries to create a healthy portfolio and lower your risk. 

You can also think of diversification like a fruit stand. Instead of just selling apples or just selling oranges, you sell a variety of fruit. This way, if there was a shortage of, for example, Georgia peaches one year, you’d still have other fruit to sell and make money.  

The same concept applies to value investing. Remember: as a value investor, you’re investing in quality companies by purchasing stocks at bargain prices. 

Diversification can protect you against unexpected, unpredictable events that hit a certain company or industry harder than another. 

Here’s how you can effectively diversify your portfolio when value investing:

  • Don’t invest in multiple companies for the sake of diversifying. A smaller portfolio is easier to manage and equals less transaction costs. You also don’t want to invest in mediocre companies just to diversify. This practice can increase your risk!  
  • Invest in around ten great stocks. This is an approach taken by many value investors. It helps you avoid diversifying too much, which can actually result in lower profits. You also become an expert in the stocks you own. 

In short, purchase different companies, preferably in different industries, as a diversification strategy. 

2. Calculate your margin of safety.

Warren Buffett calls “margin of safety” the three most important words in investing. The margin of safety is the difference between a company’s current share price and its intrinsic value

In layman’s terms? Pay less than what the stock is actually worth. For example, buy $10 dollar bills for $5 dollars. 

This difference between value and price gives you a safety buffer. Say that the company you’re investing in doesn’t perform as well as you expected. Not to worry. A margin of safety gives you a cushion to make mistakes in your fundamental analysis

Basically, the lower your purchase price is compared to the intrinsic value, the lower the risk you take, and you still have a good chance to make money. 

Make conservative estimates about the intrinsic value of a company. Buy when the stock’s price is way below this value. 

So how big should your margin of safety be? 

According to Warren Buffett, “The more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.” The right number depends on multiple factors like

  • How accurate you think your intrinsic value estimate is
  • How much money you want to make
  • How vulnerable the company is

But to be safe, you could go for a margin of safety between 50-100% (aka your purchase price is 50%+ lower than the company’s intrinsic value). 

In short, margin of safety is based on price. It helps you make money by not losing money.  

3. Average-down your purchase price.

Averaging-down means that you purchase more of a stock you already own after that stock has decreased in price. 

By doing this, you lower your average purchase price for those stocks in your portfolio, increase your margin of safety, and lower your downside risk. 

Here’s an example: say that you purchase 100 shares of a stock for $50 per share. Soon after, the price of the stock drops to $40 per share. You purchase another 100 shares at this price. Because you purchased 100 shares at $50 per share and 100 shares at $40 per share, your average purchase price is $45 per share

You have successfully averaged down. This strategy helps you buy more stocks in a company you like at a lower price. Granted, there is some risk here. The price of the stock could keep dropping, losing you money on your investment. 

This is why fundamental analysis is so important with value investing. A low price alone shouldn’t be the only reason to buy a stock. A fundamental analysis helps ensure that you’re investing in quality companies! 

CAUTION: AVOID STOP-LOSS ORDERS

Averaging-down is more challenging when you use stop-loss orders (another way that investors try to limit downside risk). 

Here’s an example of the problem with stop-loss orders with value investing: 

Say you buy stock at $50 per share and want to sell it. Maybe you set a stop-loss limit of $30. The stock will sell automatically if the stock price drops from $50 to $30. This automation can help protect you from further losses, BUT it also limits your ability to average down.

Why? Because if a stock is an excellent buy at $50, it would be an even better buy at $30. You get the same value for a lower price. If you purchased stocks at $50 and then more stock at $30, your average purchase price will drop to $40.

As a value investor, avoid placing stop-loss orders. You want to buy when prices decline (aka buy more of a quality company at a bargain price). Averaging-down helps you make money when you buy, not when you sell. 

Reduce your downside risk even more

Along with these three strategies, only buy companies you understand. In the words of Peter Lynch, “Never invest in any idea you can’t illustrate with a crayon.”

Also, ensure that these companies have a consistent track record of high profitability, smart management decisions, and low debt levels. Lower your downside risk to have the best possible odds when investing!

Learn even more about how to reduce your downside risk and value investing by signing up for the Value Investing Bootcamp: How to Invest Wisely on Udemy. This course helps you learn how to become a successful value investor step-by-step. Check out the course here

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Elisabeth O. is an MBA graduate with a specialization in International Finance & Investments and over six years of financial writing experience. She is passionate about long-term investing to build wealth, avoids day trading and speculations, and loves a good Warren Buffet quote.