What Do You Understand By ‘Risk’ in Investing?

“You must know your risk appetite before investing.”

“Markets are risky and can crash 30%. Invest later.”

“I am a risk-averse investor.”

“I can’t take risk with my money. This stock can fall 20%!”

“Investing is risky. And I don’t have the risk-taking ability.”

These are some common statements/advice I’ve heard from investors and financial advisors over the past few years, and especially when stocks prices are on a correction mode.

Everyone talks about ‘risk’ when it comes to investing in stock markets. But ask them what ‘risk’ really means, and you can sense the earth moving from under their feet.

The ‘risk’ word sounds fancy, and so it is spoken at will to show the sophistication of the discussion involved.

But, dear investor, risk isn’t a number. Like a 30% fall in the stock markets, or a 20% fall in your favourite stock.

What does ‘risk’ really mean?
It is foolhardy to try to reduce risk to a single figure.

As per Warren Buffett, the risk of holding any stock (or for that matter, any investment) is only the ‘permanent loss of capital’.

A permanent loss of capital occurs when a stock goes down because of worsening business operations and stays down for a very long time or even forever.

For example, if a company goes bankrupt, or its earnings power drops permanently, then shareholder value will also become permanently diminished.

See the red line (Stock B) in this chart. That is ‘risk’ – invested capital permanently lost.

Stock markets falling and your stock prices coming down with the fall isn’t ‘risk’, simply because such a fall is not permanent if you own good quality companies in your portfolio.

How to avoid permanent loss of capital?
Of course, as an investor, you won’t want to buy a stock that can wipe out your savings (like Stock B in the chart above).

But how do you avoid such permanent loss of you capital?

Here are two simple rules that can save you from the blushes (and pain) of seeing your savings lost permanently.

Rule No. 1: Know what you are getting into
Now that’s very important. You need to understand the business whose stock you are buying.

Investing (or speculating) on a free tip you’ve received from someone else is a sure shot way to lose it all. And you won’t know what struck you, as you never knew what you were getting into.

So, do your own homework before investing in a stock and buy only when you are convinced that the company isn’t going to go down the drain in the future.

Remember, risk always comes from not knowing what you are doing, in life and in stock market investing.

Rule No. 2: Avoid leverage
Never borrow and invest (or speculate). Leverage (borrowing) just magnifies your losses, and can make temporary setback permanent.

Just look at people in the western world who took all kind of leverage (home loan, credit card debt, personal loan, automobile loan) without being sure whether they’ll be able to pay them off in the future. Then they also incurred heavy losses in their stock market investments.

Imagine yourself in such a scenario and you’ll understand why this is the ‘risk’ you must not be taking at all.

What next?
Even though some stocks won’t work out the way you expect, you’ll make money over the long haul if you are clearly aware about the ‘risks’ you are taking.

Always remember, risk comes from not knowing what you are doing. Because when you don’t know what you are doing, you can lose it all…permanently.

Tip of the day: The next time someone – say a friend or an investment advisor – were to ask you what your risk-taking capacity is, ask him what he understands by ‘risk’.

Really, just do it and get ready to enjoy the silence that follows.