Risk and the Art of Getting Rich
If you want to make big money, you have to give up some safety and comfort — but there are ways to minimize the dangers to your portfolio.
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One of the most basic concepts in finance is the risk-return trade off, which states that the cost of higher returns is higher risk. In other words, there is no such thing as a free lunch. To generate a return, it is necessary to take a risk in the form of time, money, or effort.
The risk/return relationship is unavoidable and is largely symmetrical. The more risk you take, the greater the potential return. For example, a government bond or a savings account has a low level of risk but will only deliver modest returns, while an investment in cryptocurrencies or growth stocks offers the opportunity for very large returns but with a much higher potential for substantial losses.
The risk-return tradeoff is not only the heart and soul of investing but of almost everything that we do in life. We must constantly decide if we want to play it safe or go for glory by taking riskier action.
In investing, identifying and dealing with risk will determine your ability to build wealth more than anything else. The challenge is that risk is not easily quantifiable. It is the great unknown factor that is always lurking and can turn what looks like a sure thing into a disaster. But if you don’t take risks, then you can never produce truly substantial returns.
When dealing with investment risk, there are two key considerations. The first is to reduce it by gaining additional knowledge about the investment you are making. The better your understanding of what can go wrong, the more control you can have over your actions. The second goal is to be in a position to minimize the damage that is done if your luck turns bad and risk hits you hard. You have to be ready for the failures that are sure to occur when you ramp up your risk-taking.
The most basic approach to risk mitigation in investing is diversification. The more stocks you own, the less likely it is that any single disaster will occur and destroy your capital. The more diversified your holdings, however, the less likely you are to enjoy substantial returns from one or two good ideas.
Even a well-diversified portfolio can not protect you completely. There is still economic and market risk that can not be eliminated, no matter what you might do. Risk is always out there, and it is empowering when we can identify it with some level of precision.
The richest self-made people in the world all have one thing in common -- they built wealth by taking very large risks. No one grows super-rich by putting money in a bank savings account. They become billionaires by putting capital in higher-risk investments that can produce substantial returns over a long period of time.
This formula applies to both entrepreneurs and investors. Entrepreneurs like Elon Musk or Jeff Bezos not only risked their capital but also years of their lives to develop their enterprises. They were willing to lose everything, overcome substantial risk, and that is what allowed them to have such great levels of success.
The greatest investors in the world tend to do something similar. They take very high levels of risk by holding very concentrated positions in their best ideas. Warren Buffett famously stated that "risk comes from not knowing what you’re doing."
The greatest investors in the world did not build substantial wealth by holding index funds and highly diversified portfolios. They build wealth by finding great ideas, doing substantial research, and then betting big. They are prepared to be wrong, and when they are, they do their best to limit the damage and then aggressively pursue the next great idea.
The lesson for individual investors is that if you desire to produce better returns, then you must take on more risk. The primary risk will be holding larger, more concentrated positions. A secondary risk will be buying stocks that are still at an early stage of growth and may fail to develop.
If you decide to take the route to higher returns by holding concentrated positions in higher-risk, smaller stocks, the key question to ponder is how to control the risks you are taking.
There are two things you can do. The first is to know as much as you can about the stock you are buying. Understand its business and how it will grow quickly over time. Know the financials and know the industry. Knowledge reduces risk.
The second way to deal with risk is to use a trading methodology that reduces your exposure when price action is poor and increases it when price action is positive. Adjusting position size as the stock develops allows you to control risk.
When you combine knowledge of fundamentals with adjustments in position size, you are able to mitigate the risks that you are taking while preserving the ability to produce exceptional returns.
There is no way to avoid risk, but if you embrace it with the correct approach, it can make you rich.
At the time of publication, DePorre had no position in any security mentioned.
