How to Measure Risk

And Get Rid of It

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How to Measure Risk

And Get Rid of It

Intro

Risk is everything in life. In order to get ahead, you have take some risks, and in many instances, risk is assumed without willfully doing so. Let’s face it - risk is a part of life. The biggest challenge is learning how to control it because if you’re unable to effectively manage risk, you’ll be miserable.

Most people don’t proactively manage risk because it’s easier to go through life without thinking about it. But the reality is, you can’t get anywhere without taking risks—this is especially true when it comes to investing.

Manage risk properly, and you’ll set yourself up for a wealthy retirement. Ignore it, and you could end up broke.

I’m guessing we all want to manage it well, right?

That’s why in this brief write-up, I’ll show you exactly how to handle risk – the right way.

Risk in a Nutshell

Just walking down the street exposes you to all kinds of risks. There’s always a chance a car could hit you, for instance, but you’re not constantly worrying about that—you’re focused on putting one foot in front of the other to get to your next destination.

Investing is similar. Walking down the path of stocks, there’s always the risk of a market crash. But let’s not spend time worrying about that. Instead your focus should be on the company’s steady steps toward consistent and predictable earnings.

 Okay, it’s not the best analogy, but you get the point.

The truth is, stock prices go up and down all the time, with the inherent volatility of price movements being perceived as risk by most investment professionals. Market researchers often call this volatility (the persistent up & down stock price movements) a measure of risk.

That’s true if you’re thinking in the short term, like days or weeks. But we’re playing the long game here—and that’s where things get interesting.

The Accurate Way to Measure Risk

Warren Buffett has a brilliant perspective on measuring risk.

Considering volatility as a measure of risk? That’s nonsense, he’s said.

Buffett has regularly been critical academics and the financial industry’s reliance on volatility as a measure of risk. Just looking at price charts doesn’t tell you the whole story, and oftentimes none of the story at all. Instead, it’s far more effective to reduce or eliminate business risk by focusing on companies with stable and predictable earnings.

Why is that important? Companies with consistent earnings are generally more resilient during market fluctuations. They have earnings power based on established business models, solid customer bases, and predictable revenue streams, making them less vulnerable to economic downturns.

This means you can invest with greater confidence, knowing that even during rough times, these companies are likely to maintain their performance – and rebound if they suddenly drop in times of market turmoil.

So, rather than obsessing over short-term price swings, shift your focus to understanding the business itself. Focus on business fundamentals. Spend less time analyzing charts and more time reading about the company’s cash flow, its competitive advantages, and its management team.

Here’s a great step-by-step strategy to help you make this shift. Trust me, it’ll save you a ton of time and lead you to smarter investment decisions.

How to Find Risk

Because you’ve made it this far, I have a gift for you.

Here’s a concise three-step strategy to identify and assess business risk by reading the annual reports of companies:

Step 1: Review the Management Discussion and Analysis (MD&A) Portion

Start with the MD&A section for insights on the company’s performance, challenges, and future outlook. Look for how management addresses risks and their strategies for mitigation.

Step 2: Analyze the Financial Statements

Examine the income statement, balance sheet, and cash flow statement. Focus on metrics like revenue stability, profit margins, and debt levels to gauge financial health. Consistent earnings and healthy cash flow indicate lower risk. The key word is consistent, so as always - be sure to evaluate these fundamental metrics over the course of time.

Step 3: Check the Risk Factors Section

Read the Risk Factors section to identify potential threats to the business. Assess trends over time and see how effectively the company manages these risks. A company that openly acknowledges and plans for risks is generally better positioned to handle challenges.

Conclusion

By following these steps, you’ll better understand a business’s risks and, in turn, minimize any investment risk for yourself. However, at the end of the day, you need to think critically.

You can gather all the information available, but if you don’t process it in your mind, it’s essentially useless.

I often reflect on this quote by Henry Ford: “Thinking is the hardest work there is, which is probably the reason why so few engage in it.”

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.

The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.