@zerenia that’s very well put. I didn’t really touch upon some other tools by which investors reduce risk, the most common method being diversification across asset classes, industries, and geographies. I was intending to talk about these things as well as how investors could try to take advantage of some of the seeming “irrationalities” such as overreaction or under-reaction to certain market events in a separate post. I guess my post wasn’t so much intended for actual professionals in the industry but more toward individual investors who might make rash decisions to buy overhyped stocks or not sell a bad stock to avoid feeling that they made a bad decision. Thanks for engaging with my post though.

@zerenia no

When you make a new decision with your money, it can be sometimes quite challenging to prevent your emotions from being in the driver’s seat. It’s because our financial decisions often tend to be influenced in large part by our feelings more often than we are aware of it. This includes our investment decisions as well.

An investment decision is a dynamic enterprise with lots of moving parts. First of all, there is inherent uncertainty. You have to accept the fact there is never a guaranteed return. The world is constantly changing with new emerging information that it is practically impossible to predict the outcome of any scenario with no margin of error. Having a smaller margin of error gives us more confidence.

For example, let’s say that you’re a real estate investor and there is a certain development project that looks very attractive. The project is the construction of a residential complex with high-rise buildings which, once they’re done, will include luxurious apartments and large workspaces. There will even be shops, cafes, and restaurants. You can even add that the location itself is very beautiful.

It sounds perfect, right? Nothing can go wrong. Well, if you never checked the market conditions and decided to go ahead when the demand for housing was starting to recede, then that can be a problem. Because by the time you finish, you have to find people and businesses who want to buy or rent these spaces so that the project starts to pay for itself and you get your required rate of return.

In addition to market conditions, you have to keep an eye on macroeconomic factors such as inflation and interest rates as well. In an environment with rising inflation, you can expect a hike in the interest rates, which will make it harder for consumers to borrow a home loan. While it might sound daunting, doing your research about the market and general economic conditions is a necessity to have a margin of error that you’re comfortable with.
This doesn’t necessarily mean to say that we have to be robots to make good investment decisions (although their use is certainly helpful). Even the most successful investors can make erroneous investment decisions and lose a lot of money. So, there is no need to feel afraid in the face of risk. After all, there is no gain with no risk. The important part is how you manage the risk.

The same philosophy applies for investing in the stock market as well. The key part of investing is that you have to seek a desirable return that justifies the level of risk that you’re taking. In other words, you have to educate yourself about the kinds of risks that are present in the companies and industries, in which you invest. That way you act as a rational investor and base your intuition on your research rather than following the crowd. Following the crowd is not always bad. You just have to choose the right time to do it and know when to go the other way.

The cliché goes: “Price is what you pay. Value is what you get.” You’ve heard this dictum probably many times if value investing has ever crossed your mind and you decided to learn more about it. Basically, you want to look for undervalued stocks whose prices in the market are below their fair value. These are companies that are fundamentally sound to become great companies one day. They just haven’t been steered in the right direction yet.

By picking those stocks, you also give yourself a margin of protection to minimize your potential losses in the event that things don’t go according to the plan. Even when you’ve found a great company, your investment thesis might not materialize until the necessary changes happen within the company such as a change in the management structure. Therefore, you have to follow closely what is actually happening with the company.

However, if those changes do not happen within your expected timeframe, or worse, the company actually takes a bad direction, then it’s time to let go. This is another important aspect of not being an emotional investor. You have to be able to accept when you are proven wrong and look for alternative opportunities. In other words, don’t get too emotionally attached to an idea just because it felt great in the beginning and not see the evidence that it wasn’t such a great idea.

I was listening to a podcast about this on WSJ. Apparently, people’s credit scores across the U.S. have increased to a record high during the pandemic. As a result of the government stimulus payments and the general forgiveness of the banks toward late payments, people’s scores have gone up. What do you guys think about this? Do you think it will be easier/more convenient to get a home/auto loan in the future due to this change?