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How To Truly Measure Risk

Disclaimer : Anything mentioned in this post is not financial advice and is for informational purposes only. We do not recommend buying or selling any securities that are mentioned in this article. All investments carry risk and there is no guarantee of profit nor protection against loss. WealthGap does not provide any legal, tax, or accounting advice.


In business school, they teach diversification of investments can decrease portfolio risk. Mathematically speaking, each additional security will decrease a portfolio's "risk", which is only true up to a certain point. Diversification is sufficed when you have a basket of 10-20 stocks. Excessive diversification will dampen returns over time because there are limited winner stocks within your circle of competence. Jeff Bezos, Mark Zuckerberg, and Bill Gates...etc are the richest billionaires in the world because their wealth is concentrated into one stock. Put all your eggs into one basket if you know what you are doing. Diversification is for the ignorant.

Most textbooks define risk as volatility, which is the up and down movement of stocks and this school of thought is extremely flawed in my opinion. Why would a business be considered riskier when its stock price moves up and down more violently? If Amazon's stock price moved up or down 7% in one day, would you say Amazon as a business has become "riskier"? I believe there are a couple elements that make up the true measurement of risk.

Debt Level

If a company needs to constantly issue debt to cover operation expenses, it means this company is not generating enough cash flow and its business model is questionable. If a macro event such as the corona virus pandemic occurs, a debt heavy company would not be able to service its debt. This does not mean every debt issuance is frowned upon. A company that truly needs to issue debt for capital expenditure for long term profitability is justifiable.

Dying Industry

Investing in a company conducting business in a dying industry is extremely risky because eventually it will lose all of its business and go bankrupt. An example would be the newspaper industry. There will be fewer and fewer people who read physical copies of newspaper and eventually most newspaper companies will be out of business.

Barrier to Entry

Is the business easy to replicate? If so, increase in competition will drive margins down. Out of the FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks, Facebook has the weakest barrier to entry in my opinion (Disclaimer : This is not a recommendation to buy or short Facebook). Anyone can code a new "Facebook". Worse, if someone makes a better social media site, Facebook will lose a LOT of customers. In fact, Facebook only maintained growth because they bought out their biggest competition Instagram, which was an ingenious move. If you can't innovate, horizontal integration is the way to go.

Sovereign Risk

If a company or its major business partner is located in a country where there is weak enforcement of law or is in war, there will be significant sovereign risk.

Regulatory Risk

A business that is subject to regulatory risks is not a wonderful business. The best example would be the firearms business. If lawmakers suddenly limit firearm purchases or enact stricter requirements for gun buyers, this industry would lose a ton of demand.

Capital Intensiveness

A great business is one that does not need constant capital expenditure and still grows. The less reinvestment needed the less risky the business. One example of a risky business that is capital intensive is airlines. First and foremost, airlines are extremely dependent on fuel prices, which is out of their control unless they hedge their risks with futures (an additional cost of conducting business). According to Forbes, 80-85% of airline employees are in unions, which means it is not easy to fire them to cut costs when bad times come. Airlines have to buy new planes every couple years that requires huge capital expenditures. Moreover, the planes have high maintenance, are subject to parking fees at airports, and require insurance...etc. Surprisingly, plane tickets have become cheaper (adjusted for inflation) in the past decade while these costs have soared. As I am writing this article, Warren Buffett just announced he sold his entire position in airlines. Great minds think alike :)

Best Way To Mitigate Risk

When you invest in wonderful businesses and are willing to have the patience to hold your positions for at least a couple years, it would be akin to making riskless investments. Don't invest any money that you foresee you will need to use in the next couple years. You don't know when recessions might come and when you need cash you would be forced to sell stocks at depressed prices. Stocks prices almost always recover from recessions so you just need to have enough liquidity to weather those times. Consistently investing in those businesses from your paycheck every week/month for a long period of time will make you rich eventually. Don't worry about stock prices being higher than previously because if you look at Amazon's stock price chart you would know Amazon was cheap every single day in the past 20 years. Good luck to all of you on the road to the 3 comma club.

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