It was early in my investing career and risk management wasn’t even a term I really understood. I was researching an oil explorer who was drilling in an area that had a lot of previous successful drilling results. If the drill rig resulted in an oil discovery the share price for this company would have easily achieved multi bagger returns.
If it didn’t though the share price would fall at least 95% from my entry. Was I thinking about this? Of course not, all I could think about was the awesome returns I was about to make. I jumped in feet first and purchased some shares.
Unfortunately the drill results were unsuccessful and the stock was 98% down on open! Now I say unfortunately but in reality it was a great loss that taught me a great lesson. The downside is more important than the upside!
A Focus on Risk Management
Without a focus on risk management you have absolutely no chance of achieving any sort of long term success in the stock market. Can you make large profits without having a risk management plan in place? Absolutely. Can you keep those profits though? Absolutely not.
What does this mean from a practical perspective though?
For me personally, risk management is all about focussing on factors that reduce your chances of incurring large losses rather than solely focussing on factors that can make you large profits.
Let me give you another example. I recently stumbled upon a company which ticked a lot of the boxes in my investment strategy. They had a great asset which was smack bang in the middle of one of the best gold mining provinces in the world.
Does it have the potential to provide shareholders with multi bagger returns? I have no doubt that it can.
Upon closer inspection though I found 2 factors that set off my risk management alarm. Firstly the director owned only 1% of the register. This is a big red flag for me and the next issue will show you why.
Secondly the company was also low on cash. For my personal strategy this isn’t a huge deal as I simply wait for them to raise enough cash and I aim to get in as close as possible to the raise price.
So as per usual I put the company on my watchlist and a few weeks later the company went into a trading halt for a capital raise. I was shocked however with the excessive amount that they raised, the discounted share price and the heavy dilution that occurred.
It was a terrible move by the CEO who should have raised a small amount of cash for the drilling program considering the high potential for success.
Now in my opinion this error would never have happened if the CEO had a substantial amount of shares in the company. Who would heavily dilute themselves?
So even though this company had huge upside potential, it also had huge downside potential. From a risk management perspective, the key is avoid putting yourself in this position.
To ensure risk management is at the forefront of your mind at all times, you will obviously need to have an investment strategy. If you don’t have one and you want to see some examples to help you get started. I also have some great examples from successful investors you can read.
You also need to ensure that your strategy not only analyses the factors that would contribute to share price appreciation, but even more important are the factors that can lead to share price depreciation!
Ask yourself what could go wrong? What’s the worst case scenario for this stock and what would the impact to the company and the share price be if this eventuates?
By doing this you can determine your risk/reward ratio. This will highlight to you what your possible return is compared to your possible loss.
Investopedia defines this metric as:
The risk/reward ratio marks the prospective reward an investor can earn, for every dollar he or she risks on an investment. Many investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns. Consider the following example: an investment with a risk-reward ratio of 1:7 suggests that an investor is willing to risk $1, for the prospect of earning $7. Alternatively, a risk/reward ratio of 1:3 signals that an investor should expect to invest $1, for the prospect of earning $3 on his investment.
Now this ratio is personal to every investor/trader so be sure to determine a ratio that makes you comfortable and allows you to sleep at night without always being on edge that a major blow up may substantially impact your portfolio.
I hope that this article has helped raise a few questions in your mind on how to approach equity investing from a risk management perspective.
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