How To Use Risk Analysis To Make You A Better Investor

What is risk analysis?

Shares - and for that matter any type of investment or speculation - carry an inherent risk. Mainly, the is the risk to capital - will you get your money back?

To quote an old saying in finance, the return of your money is more important than the return on your money.

There is no guarantee of any profits, dividend or interest payments, rates of return or any return at all. There are however, degrees of risk.

By using risk analysis techniques it is possible to define types of risks and the level being taken and then to compare them with potential returns. This is known as the risk / reward ratio.

It is by having a deep understanding and amazing ability to forecast returns and compare against other types of investment returns that Warren Buffett has been able to amass such a fortune. He is able to project rates of return into the future with reasonable accuracy and then compare that with other potential returns. He famously judges potential investments against 'risk free' T-Bills (United States government debt).

If any of us had just half his understanding of risk analysis and comparison skills, we would be exceedingly wealthy!

So, to help you in your quest for investment profits, the pages listed below in this section will offer some definitions of useful terms in understanding risk levels. There will also be space offered to the formulas required to calculate important ratios for yourself.

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In the case of Mr Buffett, he uses some standard concepts to estimate the value of a business, but some other more qualitative concepts to try and judge what he calls the business franchise and therefore the extent to which their business is predictable into the future. He can then understand approximately how much he is paying in today's money for profits as far as ten years into the future!

It is very powerful stuff and well worth studying for every investor.

It is worth noting that some of these calculations are used less for risk assessment and more for company assessment. However, by definition, understanding and valuing a company is an integral part of understanding the risk of investing in it.

As is mentioned on other parts of this website, a keen understanding of the risks being taken in a potential investment and in the holdings in a given portfolio is one of the key factors that separates amateur from professional money managers (information here).

Understanding the risk levels being taken in a portfolio is a vital skill and one that asset allocators spend a great deal of time learning and lots of computer processor time monitoring. We private investors should learn to follow the professionals!

Within the world of Wall Street and investment banking, risk analysis is taken very seriously. However, as an outsider looking in, it appears as though hedge funds (information here) take the subject most seriously, largely because of the amount of their own money that is typically managed with a fund. The fact that a number of hedge funds 'blew up' during the 2008 stock market crash, but did not prove to be vital to the financial system suggests that somehow they had managed to enclose their risks in large part within the fund itself.

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Despite this, all financial institutions will use some form of daily mathematical tool or model to try and understand their balance sheet as closely as possible. Some form of risk analysis matrix will be used for both current risk assessment and forecasting. Typically finance companies will have some form of Risk Management Team on staff (this is not something to be outsourced!) to help provide insight and answers.

One of the tools (which has been criticised heavily since the 2008 Wall Street crash) is VaR - Value at Risk. This is used to provide a daily snapshot (usually at a pre-set time of day, or the close of business) into the balance sheet of the investment bank that day. While it was used to help understand the balance sheet, it appears to have provided reasons to management as to why they could further leverage their assets, which isn't exactly what risk analysis techniques were designed for!

Looking at the underlying situation

There are other ways of looking at this. As a potential owner it could be interesting to do a SWOT analysis (information here) to get a better feel for the likely trading position of the company. By delving into the Strengths, Weaknesses, Opportunities and Threats facing the business it can offer an enhanced insight into the long-term prospects.

Sometimes it can be a simple job of finding out what tools the company uses to help it run efficiently. For example, we all know that offers amazing tools that enable a business to stremline sales and customer relations. Is the company using such a tool? For smaller businesses, there are other services that can help their situation (information here).

A fairly standard cost-benefit analysis can also be used to try and understand the impact of decisions. Additionally, a sensitivity analysis (information here) can be used to understand the potential problems in a choice.

It also might be interesting to look into the mathematics of a decision making process being taken as an investor. One method for this is a Monte Carlo Simulation (information here). It is used to analyse the potential risks in making a particular decision - therefore, in this case it would mean looking at the risk of taking a decision about risk. This is a very high-end mathematical approach, but one used often within investment banking.

Of course, for the small amounts that most private investors manage, there are limits to just how useful assessing portfolio risk can really be. There have been, for example, several Nobel Prizes for Economics awarded to individuals that have studied portfolio risk management. While it can be interesting and instructive, it is a very complicated subject for most mere mortals (such as your author) to truly understand.

Ray Dalio

In his 2014 book, Money: Master The Game, Tony Robbins spends considerable space on the subject of risk in investment portfolios. His writing was guided significantly by legendary hedge fund manager Ray Dalio.

Possibly the main breakthrough of the book is in describing to a mass audience how Ray Dalio thinks about risk when compared to most of the rest of the fund management industry. In an ideal world, we would recommend you buy the book and work through it - it is definitely worth your effort if you are committed to a better financial future.

Dalio explains that most investment firms recommend that investors save their money according to pre-set percentages. We have surely all heard of 50/50 splits between equities and bonds. However, the breakthrough comes by describing that this equalises the money being saved, but not the risks being taken on within the portfolio. The two types of assets are reasonably correlated, but there is much more risk in the stock market than the bond market. It is so true and none of us had really thought it through that way before. Buy the book and learn more!

Thus, the subjects discussed in the pages listed below offer descriptions of the most important risk analysis concepts and ratios that a private investor ought to face and really must understand.

Click here to learn about:

How Do Different Types Of Risk Influence A Portfolio?

Investment Definitions

Understanding A P/E Ratio (Price To Earnings Ratio)

Why Low Risk Can Be Good

Why Selling Investments Is THE Most Important Skill You Can Learn In Investing

What Is A Stop-Loss?

Understanding Gearing And Borrowed Money

What Does The Return On Capital Employed (ROCE) Tell Us?

What Is Alpha? Can You Outperform The Stock Market?

Does Correlation Influence Portfolio Diversification?