This is a case study of the factory fire incident at SVI, in which the damage had not been clearly assessed, causing the stock price to fall more than 34% within 2 days. It made me think of the issue of diversifying risk in an investment portfolio.
- Nothing is certain in this world. Not even the stock that we have extreme confidence in and have studied extensively. Because unexpected events can happen at any time. Not that we should stress out over it so much, of course, because we can’t control anything in that regard. What we can control, however, is to limit the risk in our investment by diversifying our stocks and not hold any particular stock in such large amounts. Because like I said, unexpected things happen all the time and we ourselves might mistakenly analyze some things. According to the principles I taught on Jitta 101, is to have around 20% of each stock in your entire port, so that even if you make a loss of SVI up to 34%, you will only make about a 6.8% loss in the big picture of the portfolio, which isn’t that big a deal. The returns from other stocks could make up for this loss, thus, preventing your entire port from making a loss.
- In the case that we have unequal proportions of stocks in our port, the majority of our invested capital should be invested in a company that has enough business risk diversification. Of course, these are companies that have high Jitta Scores. In the case of SVI, the company does not have much risk diversification, because they only have orders from a few customers and a few production plants. When there is an unexpected crisis, their revenue could greatly decrease; for example, in the case of having to close down a factory due to a fire -even if they could reopen it, customers might have already found a new producer.
On the other hand, great businesses have good risk diversification, for example, their revenue might come from millions of customers, they might have different types of businesses, many distribution centers and such, ensuring us the company’s income stability (in the short-run, it might be affected by unexpected incidents but probably not on a large scale that would make the company lose money).
For example, Priceline (the owner of priceline.com, booking.com, agoda.com), who is most likely the largest online travel agency in the world right now. This company has businesses in many countries around the world, has more than 200,000 hotels for customers to choose, and has millions of customers who do bookings with them. Therefore, even if some countries have, say political problems that halt tourism, or some hotels cease operations, Priceline won’t have a problem. The risks that these businesses will face more of instead is the risk from substitute products or competitors. But anyhow these two cases are not unexpected incidents that happen overnight, because competitors will slowly steal market share, allowing time for us to understand the situation and sell out the stocks without making great losses.
So in the case where we invested in companies that aren’t so great, we could limit our risks by limiting our investment capital; perhaps around 10% of our total capital, instead of 20%. So, even if the stock price dropped 34%, we would only be making a 3.4% loss in our port. Understanding where a business’s revenue comes from is, therefore, essential and will help maintain our confidence when something unexpected happens. (I discuss the subject of questions that need answers to ensure that we are investing wisely on Jitta 101 Part 4, 32.00 min (under Jitta Note) You can view it at Jitta 101 Part 4)
- If we have a good risk management strategy and mainly look at the overall portfolio returns, we wouldn’t be too stressed about the mistakes that cause us to lose money from stocks in each time. On the contrary, we would receive lessons on those mistakes so that we could improve in the next time round.
Therefore, to continuously invest happily, we must know how much risk level we can handle and adjust our risk diversification strategy accordingly. With that, we can become more relaxed and carefree throughout our investment life!