How to Not Lose Money Investing in Stocks

Today I’m going to explain how great investors protect their investments from losing money and how you can do the same.

Warren Buffett has 2 famous rules:

1. Don’t lose money
2. Don’t forget rule 1

If you want the upside returns of the stock market, you need to know how to protect your money.?

You wouldn’t jump in the UFC Octagon without learning offense AND defense to protect yourself. Boxing's mantra of “Hit and don’t get hit”. Work out a way to hit, without getting hit.

You wouldn’t have sex with someone you just met without protection. Work out a way to have fun, without catching STIs.

Investing is the same. Work out a way to keep the upside gain (return), without the downside (loss of money).

Unfortunately, many beginners and even seasoned investors never grasp this critical concept. Leaving them exposed to getting punched in the face by the stock market.

Risk Management isn’t Sexy

Here’s 3 reasons why most beginner investors don’t protect their investment:.

• They don’t know

Many beginners may not be aware of ways to reduce their risk of losses. Let alone how to actually do it.

• Groupthink & Fear of Missing Out (FOMO)

Some buy a stock without thinking first. They get swallowed by the euphoria of quick wins and easy money, only to be spat back out poorer than they started.

• Boring and difficult to stay disciplined and consistent

When you hear risk management your brain turns off. Fact. If I say don’t lose all your money, your interest peaks.?

Have no fear, this can be learned and implemented in every investing strategy. By the end you’ll understand and be on the look out for those fists the market swings your way. You will also have a much better understanding of how you can create and modify your own investing strategy.

4 Step Risk Management Process

Here is a risk management framework I learnt whilst in the Australian Mining Industry. It is arguably one of the safest industries in Australia because of the prioritisation of risk management. As they say, the legislation is written in blood (laws changed with each death or major incident).

1. Identify the risk

Recognize and understand potential risks that may impact your objectives.

2. Assess and Evaluate the Risk

Once risks are identified, assess and evaluate them by determining their likelihood and impact. Prioritize risks based on their significance to gain a comprehensive understanding of which risks require more attention and resources.

3. Identify Controls and Actions

This step involves identifying controls and measures that can reduce the likelihood of a risk occurring or minimize its impact if it does happen.

4. Monitor for Risks

Implement an ongoing monitoring process to keep a vigilant eye on identified risks. Continuously assess changes in the environment, and review the effectiveness of the controls in place. Regular monitoring ensures that the risk management plan remains relevant and effective in addressing emerging threats or changes in the risk landscape.

Here are two examples illustrating the process:

The Office Kitchen

1. Identify the riskFloor is wetElectrical equipment damaged
2. Assess and Evaluate the RiskSlip over, sprain / hit head?Fire / electrocution
3. Identify Controls and ActionsNon-slip flooringRoutine maintenance inspections, test and tag equipment
4. Monitor for RisksMaintenance inspections, everyone can alert their supervisor of hazard they identify

The Boxing Ring

1. Identify the riskPunched on the chinKick to the knee
2. Assess and Evaluate the RiskYeah could be game over with a knockoutCould be game over after a couple of kicks
3. Identify Controls and ActionsHand positioning around chin, head positioning / chin downWeight distribution on feet managed, front leg able to move quicklyAnalyse opponent and understand moves to prepare
4. Monitor for RisksWatching out for punches, kicks, positioning as it happens

Now you have an idea of how risk management is applied, let’s see how it is applied in the stock market.

Applied to the Stock Market

First things first, we need to set the context for a risk assessment. So as an example:

• Investing long term - 5 years+
• Willing to invest 1-2 hours a week researching and monitoring investments

Why is this important? If we were investing for less than 5 years, volatility (how much the stock price goes up and down over time) would be more important. Over a long period of time volatility is not important until close to the end of the investment.?

What we should be concerned about is ways that can lead to permanent capital loss. This is the key risk successful investors care about.

“The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about.” - Howard Marks

1. Identify the riskRecessionHigh interest ratesLeverage / debt
2. Assess and Evaluate the RiskA recession and interest rates can effect the business we buy - we need to understand the impact any changes would have on the long term success of the business. This is what I call stress testing.Poorly managed debt is the quickest way to bankruptcy - this is a big risk. How much debt, how good is management are some things to think about
3. Identify Controls and ActionsBefore buying, check how the business would be impacted by a recession and interest rates. If bought, is there anything to keep an eye on?Before buying, check debt and how it is being managed
4. Monitor for RisksKeep an eye on debt levels, management decisions, etc

Now that you’ve seen an investing example lets list out typical controls. You can arrange the controls in such a way that the risk level is the same, but the return is different. We want to find the best controls to decrease the risk of losing money, and keep the upside of returns.

Indexing and Dollar Cost Averaging

• Diversification - by buying a large number of stocks through an index or ETF
• Buy routinely - no care to the market conditions, you don’t buy everything overpriced or at the peak, and vice versa
• Holding period long - not selling stocks, means less tax during the investment period, allowing compound growth to work its magic

Institutional Investors

• Diversification - by buying a large number of stocks
• Sizing - keeping the max size of an 1 single investment below a percentage of the portfolio (ie 1-5% max). Sizing in industries, sectors, asset class, is also common
• Stop loss orders - if a stock decreases in price quickly, they automatically sell once it reaches a certain price (locking in a loss, but preventing the potential of a larger loss)
• Hedging - example: making two investments, where the second counters the potential downside of the first investment
• Regular monitoring - daily, weekly monitoring of the stock, sector, industry, competitors, the macroeconomic environment, forecasting

Now investing by indexing, or through a fund can produce very similar results over the long term.

How does Warren Buffett, Howard Marks, Seth Klarman, Peter Lynch, Joel Greenblatt, Nicholas Sleep and Allan Mecham outperform the market by 10% for decades.

By using different tools to maintain return, and reduce risk.

How the Best Do It

Swap diversification for correlation

They only diversify as necessary, based on the risk of the investment, their conviction in the possible outcomes (good or bad), and only selecting the best opportunities (not every stock is going to outperform the market by mathematical definition).

Fundamentals focused

They look for investment risk in the business itself. Understanding how the business operates, what can impact it. Strong product with a competitive advantage, led by great management.

Invest in what they know

If you start investing in things you know little about, you cannot understand the risks involved and know what risks to look out for. Warren Buffett calls investing in what you know as a “circle of competence”.

Business Value as yardstick

They use the business value to assess all opportunities against each other. Not if the price is rising, going down, or if it's on trend.

Buy when on sale

By using business value, when the market prices the stock below its value, they can buy it on sale - at a discount. This is like buying $1 for 50 cents. This is called a “Margin of Safety”. Given time the market price will converge on value.

If all the optimism has been driven out of the price, it’s priced at “the world is ending”, the worst possible outcome. Rarely does the world end, so this is the opportunity to load up their portfolio.

Margin of Safety is also used to compare opportunities. Almost any investment can be exceptional, with low risk, given the price is right.?

If I was selling you a Ferrari for $1, would you need to see it? get a mechanic to check it out? get it valued? Take it for a drive??

What about $10??

$1,000?

$10,000?

$100,000?

If you already knew it was valued at $300,000, you’d already seen it, inspected, and you’d taken it for a drive, would you buy it on sale for $150,000?

Yep, that’s a no brainer.

That’s exactly what great investors do. They do their homework to reduce risk, have a list of businesses they’d like to own at a certain price, and then they wait.?

Patiently waiting for that dealership to sell it for $150,000.

Cheers,

Jack

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