The journey to becoming a wise investor might feel like cruising through the road less traveled. We are drifting away from the crowd and what they tell us to do. Most of the time, it is not easy, especially for a beginner investor like me. We are human after all, and it's natural to prioritize profits.

It is easier to forget the iron rule of investing that Warren Buffett once said: 

"The first rule of an investment is don't lose [money]. And the second rule of an investment is don’t forget the first rule. And that's all the rules there are."

We are too busy chasing for profit, so we neglect the risk. It is necessary to revisit our understanding of risk management in order to endure and survive in our investment journey. We can categorize investment risk into three types: business, premium, and self risk. I believe the risk categorization can help us to understand better where we are at now, which category we neglect the most, and which category we need to improve.

Business Risk

In investing, we know that we want to grow our assets. We put our money in one or multiple assets today with the expectation to get the fruit in the future. It is essential to be clear that we have a good understanding of the asset we choose to invest. We need to acknowledge what separates investment from speculation. The question we need to ask is, does the asset generate real value? 

We can use the things around us as the examples. How did you read this article? Is it on a smartphone? There are multiple companies that are involved in ensuring your smartphone works and comfortably fits in your palm. 

The foods and drinks that you have today. There are farmers, manufacturers, and logistic workers out there that do their jobs to supply our basic needs. Those businesses are real value-generating assets, because those assets provides value to the people and have the capability to generate cash flow. 

If the asset cannot generate cash flow, that means we are hoping for a gain from market appreciation. We hope someone else will buy what we have for a higher price. 

Thus, that kind of asset cannot be called an investment. 

It is a matter of choice on what kind of asset you prefer to invest. However, beware for any misguided information out there that might influence us to feel like we are investing, but actually speculating. With clear understanding of the asset, we must also develop our circle of competence to minimize business risk. 

A circle of competence is simply the areas of knowledge and expertise that we deeply understand. This can be developed from particular expertise. However, it is also possible to develop a circle of competence with intense and consistent learning. It doesn't matter how big the circle is; what's more important is our self-awareness about its limit. 

As Mark Twain said:

“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”

Image 1: Illustration of Circle of Competence/Source: Personal archive.

With a circle of competence, investors can have an edge or advantage because they operate within something that they understand inside and out. One memorable example is Warren Buffett's praise for Mrs. Blumkin (Mrs. B), a Russian immigrant who built a furniture business in Nebraska. 

"I couldn’t have given [Mrs. B] $200 million worth of Berkshire Hathaway stock when I bought the business because she doesn’t understand stock. She understands cash. She understands furniture. She understands real estate. She doesn’t understand stocks, so she doesn’t have anything to do with them.

She is going to buy 5,000 end tables this afternoon [if the price is right]. She is going to buy twenty different carpets in odd lots, and everything else like that [snaps fingers] because she understands carpet. She wouldn’t buy 100 shares of General Motors if it was at 50 cents a share."

Image 2: Buffett and Mrs. B./Source: Courtesy of CNBC.

With clarity of what kind of asset they invest in and awareness of their own circle of competence, investors should be well-protected from business risk. But of course, there are other risks that investors should consider.

Premium Risk




When we purchase things or services, we normally want to pay as cheaply as possible and get the best value. However, what happens in the stock market is often the opposite. 

In the past, I bought some stocks just because I was afraid to "miss the train." I ended up buying things at the wrong price. Emotions got in the way and I was stuck in buying without a margin of safety. 

Sometimes, we need to swallow the bitter pills to understand a lesson. 

This is a lesson that is quite common within the engineering world. Let's say we are designing a bridge. We need to provide a certain excess capability to ensure the bridge is safe. We design the bridge with a load capacity of 10,000 kg. 

However, we only allow a truck with a maximum load of 5,000 kg to cross the bridge. Thus, there is a 50% margin of safety when that 5,000 kg truck uses the bridge. Cars and trucks can travel safely across the bridge with minimal risk of the bridge collapsing.

Image 3: Limit the load to have a margin of safety/Source: Suzi Kim via Unsplash.

Margin of safety should be a part of investor basic requirements to avoid losing our money in investing. Even the best investors in the world still have about a 20% chance of error in analyzing future earnings of a business. 

The future is never certain. Who would have thought the world was shut down in 2020? Who would  have thought Russia would invade Ukraine? What investors can do is to stay conservative and to pay much less than the fair price of conservative valuation. 

With a margin of safety, investors can have a potential of asymmetrical opportunity. The risk might actually be low, but the potential of gain is high. 

Image 4: Timeless Investment Principles - pg. 20 - MOS/Source: THINK Tank.

The question that might arise is how we can be sure that we will not miss the train. Well, this is where the market enters our story. Benjamin Graham, the father of value investing, describes the market using an allegory of Mr. Market. 

Mr. Market is a hypothetical figure who is easily driven by euphoria and panic on any given day, and navigates his investment mostly by mood rather than by fundamental understanding. 

When Mr. Market is in the mood, he will follow the euphoria to continue buying and buying without clear understanding of what he buys. Even today, there are still several examples of good businesses that somehow don't attract Mr. Market. 

The market swings might trap investors into short-term thinking. However, investors need to understand that in the short term, the market is the voting machine. With this voting mechanism, speculators might make more money by buying and selling. But this is a zero-sum game because the sellers will always try to find buyers who want to pay a premium price.

Maybe later in the future, Mr. Market's mood swings into a panic. When he sells and panics, a wise investor might find opportunities with a greater margin of safety. In this case, the market becomes a place where the opportunities are transferred from the impatient speculators to the patient investors. Thus, in the long run, the market is a weighing machine where the price will follow the value of the business. 

The market is there to serve us, not to instruct us.

Self-Risk

We move into the last type of risk, but truly the hardest one to manage: Self-Risk. We need to have the right emotions as investors. It is not about being emotionless. It is human to have emotion, to feel joy if our investment provides a high return or to feel anxious if Mr. Market underappreciates our investment. 

The most important thing is to have humility and stay rational. Investors must focus on important key variables and knowable information related to their initial investment thesis. 

In this world of noises, not every news in the media is worthy of our attention. Today the media might spread panic, but just in a week they can easily change the headline to turn into euphoria. 

One mindset that investors should have is having an inner scorecard. We need to stay true to ourselves, especially on our fundamental investment framework and our circle of competence. Inner scorecards will help investors to focus on their own competence, behavior, and performance. 

Having an inner scorecard is valuable to avoid unnecessary action in investing, especially in the current connected world of social media, where it is getting more common to boast superior investment returns. People who don’t have a strong inner scorecard can be easily driven by emotion and get carried away with Fear of Missing Out (FOMO). 

FOMO is rarely leading to positive outcomes. Investors who haven’t developed a strong sense of managing self-risk may end up speculating or even losing future opportunities just because of short-term panic. 

Another thing that we might overlook is envy. Two sentences that I tried to keep in mind in this investing journey are:

"Someone will always be getting richer faster than you. This is not a tragedy."

Charlie Munger said it best—nothing else to add.

I hope this refresher on risk management can strengthen our journey to being wise and independent investors. Hopefully, we can all stay on this journey with the right understanding, the right price, and the right emotion.

Which risk do you find most challenging to manage?
How would you overcome those risks?