Risk, it’s something everyone has to deal with, in finance or elsewhere. In the stock market, whether you’re an investor or trader, risk/reward is one of the most important factors. I will explain how I look at risk and decide whether the Margin of Safety is large enough for me.
Everyone has a different perception of risk, some people are able to live with more risk, some people not so much. Look at life in general, moving out, choosing a different job, pursuing your dreams. These are all risky things and not everyone likes to ensue them.
How this relates to financial markets is simple. If a lot of risk makes you nervous and keeps you up at night, you might act in emotion. Emotions are maybe the biggest threat to solid returns. This doesn’t mean you should avoid risk at all though. If you’re younger, you’ll have a longer time horizon and you’ll be able to take on more risk as you’ll have more years to make up for potential losses. Risk often rewards too, this is where the famous Risk/Reward factor comes from. Making a quick €5.000 sounds great, but if you’d risk your home and all your assets it doesn’t seem like such a good deal anymore.
Margin of Safety
With every investment you do, you should be thinking about a MoS. You could look at it in multiple ways. A MoS might occur in the company you’re about to invest in itself, it could be in the price of the stock or it could be in your entire investment account.
- Companies have what is referred to as ‘moats’. This means that the company has an edge, an advantage over direct competitors. Think about Google, the leading search engine on the internet. It’s used so often that people simply say: ‘let’s Google it’, instead of saying: ‘let’s search for it’. This is a moat, the company is widely used and intertwined with our daily lives.
- The price of stock might contain a MoS when you valuate a company at for instance €50 per share and the stock trades at €45. You feel like the shares could easily rise to €60 and are worth at least €50. Because you can buy cheaper than €50, this gives you a MoS, in this case a MoS of 10%.
- Whenever your portfolio consists of solid blue chips, bonds and/or broad ETF’s, you might have a little room for more risky things. You should always consider that the money you use for riskier investments could be (completely) lost. Thus you should define for yourself with what part of your portfolio you’re willing to take that risk.
“It’s only when the tide goes out that you discover who’s been swimming naked.”Warren Buffett
How I use a Margin of Safety
As you might know I like to trade options. I have a semi-decent portfolio of blue chip stocks, some bonds and a bunch of ETF’s. I consider these my fundamentals which earn me a decent amount of money in the long term. However, I’m still quite young and not completely risk averse. I worked for a brokerage and have learned quite a bit about the financial markets in general and derivates specifically.
This fact makes me comfortable to sell a bunch of options. A lot of my ex-colleagues used to write ITM or ATM options (in the money or at the money, meaning they were immediately at risk for assignment, but delivered more premium too. Risk/Reward) and would sometimes take a loss and sometimes a big profit. I have a different strategy though. I like writing OTM (out of the money) options with a MoS of around 7-10%, depending on the underlying asset. This way I can take a few punches before getting in to trouble. This strategy has delivered me smaller but more consistent returns over the past year. As you could see in my Options Page, most of my options are closed or expired in a successful way.
“Risk comes from not knowing what you’re doing.”Warren Buffett
A Margin of Safety is crucial for long term returns in the financial markets. Thinking about your Risk/Reward keeps you from taking unnecessary bets where you could lose a huge chunk of your portfolio.
Having a MoS or thinking about Risk/Reward will not always keep you out of trouble, but it will keep your head more calm in difficult times and give you a bit of breathing space.