6 Ways I Minimize Risk In My Stock Portfolio

Published Categorized as Investment Framework
Minimize Risk In Stock Portfolio

As an investor who has started in this journey recently, my focus in the earlier days was higher and higher returns. The bull market was strong when I started, so I didn’t pay much heed to risk.

As I read investment books by industry stalwarts over time, I realized that my approach was wrong. Risk is everywhere. Yet, during bull markets, we are so optimistic about everything that we think risk doesn’t exist anymore.

For me, staying in the game matters more than growing fast now. There’s no point in growing at 30% annual returns if that runs the risk of permanent capital loss after 1-2 years. Take a look at this chart of Cisco:

Anyone who invested in the peak of the dot-com mania (circled in red) in Cisco, which was a hugely reputable company then, is yet to see any positive returns after more than 20 years.

Hence my goal is to grow at above-average returns but for a long long long time – preferably, forever.

I minimize risk in my stock portfolio in these 6 ways:

1: Investing In Wide-Moat Stocks

The best way to avoid risk in your stock portfolio is to avoid investing in risky stocks. Risky stocks promise high growth but the growth is not guaranteed.

Why?

Because the competition will look at the company’s high-growth and will jump into the fray to make some money as well. This increased competition will drive down the growth prospects of your stock over time.

Enter Wide-Moat stocks.

Because these stocks have a durable competitive advantage against their competitors, they can withstand any onslaught and grow their revenues/profits/cash flows at a healthy click. These stocks can compound for the long-term and investing in them is my first step to minimizing risk in my portfolio.

2: Anchor Stocks

I first came across this term thanks to Kris (@FromValue). Anchor stocks are basically stable companies that grow at a healthy rate and have a fortress-like balance sheet. They are usually mega-cap companies (above $100B market cap) and they may not grow as fast due to this reason.

But they provide stability to your portfolio. During bear markets, you need them to make sure your portfolio stays anchored.

3: Avoid Leverage

I have never bought a stock on margin – which is a form of debt that your brokerage lends you to buy stock – and never will. Consider this scenario:

Let’s say you want to buy the stock of Company A current priced at $100. For some reason, you want to invest $1,000 but you only have $500 with you right now. Your stockbroker can lend you the rest $500 so that you can invest $1,000. You go ahead and buy the stock on margin.

If the stock price goes down to $60, the total investment has gone down to $600. Of this $600, your share has gone down to $100 (from the initial $500 you invested) while your broker’s share remains at $500. Effectively, a 40% drop in the stock price has resulted in 80% drop of your equity.

If the total investment goes below $500, you get a margin call and your broker can sell your shares to recoup its margin without informing you.

Because one can’t predict how the stock performs in the short term, it’s best to avoid any form of leverage when buying stocks.

4: Think Long Term

In the short term, the stock market works like a casino. The stocks are influenced by traders who react to earnings, stock news, macro trends etc. They trade in and out basis the short term information and that’s what moves the price up or down.

In the long run, however, the stock prices are influenced by company-specific fundamental factors like:

  • Revenue growth
  • Profit growth
  • Growth in margins
  • Growth in free cash flow
  • Return on invested capital etc.

If you react to short-term price gyrations, you are bound to lose money.

5: Do Your Own Deep Dives

I have stopped relying on other people’s deep dives to make stock purchases. I used to do it in the beginning but a small dip here and there will shake my conviction in the stock and I will run to their Substacks/Twitter handles to see if they are saying anything about the dip.

Also, people can be wrong. Warren Buffett himself has admitted being wrong several times.

My current approach is to do my own deep dives. I go through the annual reports and earnings calls myself to build my conviction. I refer to the deep dives of other stalwarts only to see if I have missed out on anything.

Once I have built my conviction using my own research methodology, I have a lot more confidence in my stocks. I can now understand the price movements and I am more composed when stock prices go south.

6: Diversify

Saving the most obvious, but most important for the last. Diversification helps you soften any blows to your stock portfolio.

Consider this: If your portfolio has 20 stocks (equal-weighted) and even if one of them goes bankrupt, you will suffer only a 5% loss. But if you had just 5 stocks, you would suffer a loss of 20%.

Diversification, however, varies from person to person. For some, it means 20 stocks and for some, it means 40 stocks. It’s a topic for another day. I personally own 20 stocks as of now and I think it’s a healthy diversification.

Conclusion

Risk minimization was never in my mind when I started out.

It was only after reading/watching/listening to many resources that I realized I have to protect my portfolio as much as I can. If you want to learn more, I can guide to the following people and resources:

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