Reader Question; “Investing is nothing more than gambling. Why do you waste your time with it?”

A few days ago it was put to me that investing requires little skill and is essentially no different to gambling. If that’s the case, then why do I bother investing in equities (which takes up quite a lot of my time to research and manage), rather than just buying hundreds of pounds worth of lottery tickets every month?

In my opinion, comparing investing to gambling is an intellectually lazy comparison which fails to take into account the different risk profiles of the two activities. Certainly, if I were to randomly pick half a dozen companies for my portfolio based on nothing more than names I ‘liked’ then I’d probably end up with an exceptionally high-risk portfolio. It would probably be concentrated around UK and US stocks, mostly in retail or consumer products, would take little account of company fundamentals.

Although this wouldn’t really be ‘investing’, it would really be closer to ‘betting’, in the sense that I’d be taking a guess at which share prices I thought would go up. Statistically speaking, I’d probably have about a 50% chance (at best) of getting that guess right. Brands can fall out of favour, leadership teams can mismanage or embezzle funds, new competitors could destroy my ‘winners’ and a whole host of other unforeseen events could occur that would leave my portfolio looking less prosperous than Oliver Twist.

Needless to say, I’m a little bit more careful with my money than that…

Risk Management Strategies

My primary concern, as with most investors, is not to lose capital. If I repeatedly make bad investments that lose value over time, I might as well go out and buy myself a new suit every week. I’d get more enjoyment from the suit and the end result to my net worth would be about the same. That risk of losing capital is probably my biggest concern as an investor and is my primary focus when I think about managing risk in my portfolio.

As a result, there are a range of actions I take to manage that risk and improve the odds of my portfolio growing over the long-term. This isn’t to say that I’ll never make a bad investment or that parts of my portfolio won’t be underwater at some points in time; but by following some simple strategies, I reduce my risk profile and improve the odds of my portfolio growing in value.

  • Diversification – I buy different baskets of assets that perform in different ways, are geographically diverse and generate their income from different sources. I spread my investments between highly concentrated investments in individual opportunities and a broad spread of global investment trusts.
  • Hedging – A ‘hedge’ position refers to something which offsets my original investment, acting as an insurance policy against capital loss in either the overarching portfolio or against a specific portion of it.
  • Understanding fundamentals – Company ‘fundamentals’ refer to a range of financial information that is published about a company’s structure and performance. They include basic information on turnover, profit and dividend yield, but I prefer to look at more in-depth figures on price to earnings (how much I’m paying compared to how the company’s turnover) and Return on Equity.
  • Active Management – I don’t buy speculative investments – any investment I hold, I want to hold for at least five years from the time of purchase, if not longer. Despite this rule of thumb, I also consider a small volume of ‘turnover’ in assets to get a good thing. Healthy companies will boost the performance of my portfolio, but over the long-term, some may begin to underperform or develop exposure to risks which were not present when I initially made the investment. As a result, I sell off the weakest 10-20% of my holdings each year and replace these with new opportunities.
  • Qualifying ‘opportunities’ – As someone that has extensive experience in marketing and business development, I appreciate the value of a good ‘story’. Any listed company or business raising funds will employ a specialist (possibly more than one) to manage their public profile and present the best possible image of their company performance. As such, it’s my job to be the most sceptical investor that I can and dig out the truth behind the glossy marketing materials.
  • Keeping costs low –As an external investor, I’m largely reliant on published information to make a value judgement about a company. But for every percent that I pay in costs, my investments have to work that little bit harder to recover that money. As a result, I’m extremely careful with managing my portfolio costs and keep a careful track of every pound I spend in buying, selling, holding and researching opportunities.

I’ve already written short pieces on diversification, active management and hedging, so I won’t go into much detail on these in this article. Analysing company fundamentals is a big part of my risk management strategy and is quite detailed, so I’ll be writing articles on these in the coming weeks in a series entitled Understanding Company Fundamentals.