Financial Risks

With value investing, steps are taken to dramatically reduce potential financial losses. Risk associated with financial loss is addressed through three important practices. The first and best defense against losses are the type of stocks purchased. Only the best are considered with value investing. The first section below explains this in more detail and illustrates the different tiers of stock and why the lower tiers are ignored with value investing. The second best practice to reduce risk is a comprehensive understanding of the respective industry where value investors trade. The second section below goes into a comprehensive explaination of how knowledge of the industry is essential with reducing financial risk. The final best practice to defend against losses is a fundamental understanding of a company’s financial depth, the ability to withstand years of economic turmoil. The third section below introduces this mathematical algorithm for the reader. In addition, it introduces the first financial term of many that are used with value investing – book value. This term is used throughout value investing as a standard to compare other investments against and of course the ability of the particular investment to withstand long-term negative forces and quickly recover from any unusual events.

There are still many other practices and tools to reduce risk; they include understanding how operating cash flow must be positive, using business ratios to understand trends and finally, using key performance indicators to assess productivity.

Value investing does require some volatility with the market in order to have opportunities to buy low and sell high. A static market, even one with level growth will not work with value investing. Fortunately, the market isn’t stable and volatility does exist. This volatility is driven by multiple forces: politics, interest rates, consumer patterns, environmental conditions and more. Thus, opportunity exists for value investors. However, value investors seek opportunity with minimum risk.

Investing in any financial instrument comes with risk. The absolute worse case is full economic chaos created by a meltdown of governmental authority. If this were to happen, it would not matter what kind of financial instrument an investor holds, all of them are worthless as you can’t eat paper. Some would say physical possession of gold is the only pure investment because it would be tradeable in case of world disaster. This would be true if there exists a government to enforce some resemblance of order allowing trade between producers and consumers.

Ignoring total breakdown, financial instruments do have a hierachy of risk associated with their potential to become worthless. Understanding risk aversion starts with understanding the spectrum of financial instruments and their inherent risk factors. In addition, this is further refined by size, i.e. market capitalization of the respective issuer of the financial instrument. Finally, risk aversion is also a function of the dynamic range of the respective company backing the financial instrument. The following sections provide this holistic thinking related to risk aversion, specifically as it relates to stock investments.