How to Measure the Risk of Investing in a Stock
“Risk comes from not knowing what you are doing.” — Warren Buffet
In finance, the definition of risk is commonly associated with the volatility of asset prices in comparison to their historical averages in a given time frame. Therefore, if the price of a stock moves considerably up or down from its average during a period, it is considered riskier than one that has had a stable price in the market.
Although this concept seems to make sense, I believe that there are other factors more relevant than price volatility to measure the risk of investing in a stock.
Do your own research
One really important thing to reduce our risk is to do our research on the company we are considering to buy. It’s important to understand how this business makes money (what are its products and services), and whether it has a great management team and a solid balance sheet.
As Warren Buffet said, “Never invest in a business you cannot understand”.
By researching and understanding the business, we can better estimate its fair value, which leads us to another important factor in reducing our investment risk: price!
Buy with a big margin of safety
If we can buy a great company with a big discount to its fair value, we are reducing our downside and increasing the probability of getting higher returns.
This way, our risk of not estimating the fair value very accurately is also reduced, and we are giving ourselves an additional margin to protect us against any important information we may have missed in our research.
Ask yourself these 5 questions before buying any stock
In conclusion, there are several good questions that we can ask ourselves before buying a stock:
- Can we understand the business well?
- Will this company be more relevant in 5 years than it is today?
- What are the company’s plans for growth?
- Is the stock trading at price that is considerably lower than our estimate of its fair value?
- Is the downside minimal?
Thanks for reading!
If you need a starting point for analysing companies and estimate their fair value, check my original blog post. At the end of the post I provide a few websites that offer great investing information.
Originally published at https://vitorpedro.com on April 20, 2020.
This is not investment advice. It is only by humble opinion on the topic.
