Learn to invest with Buffett

Chapter 75

Chapter 13 Avoid investment risks and prevent the "snowball" from collapsing

Chapter 13 Section 1 What are the main risks of the stock market

"There are three secrets to success: first, try to avoid risks and keep the principal; second, try to avoid risks and keep the principal; third, firmly remember the first and second." The three secrets, repeatedly emphasized, are one : Avoid risks and keep the principal.

--Warren Buffett
"In order to meet the needs of insurance customers, General Reinsurance established a derivatives trading department in 1990, but in 2005 we closed a contract with a period of 100 years. It is hard to imagine what kind of demand such a contract can meet , unless a trader who may only care about his compensation has a long-term contract in his trade book that needs to be hedged.

"Imagine if one or more firms (trouble always spreads quickly) had a position many times our size and wanted to liquidate their position in a chaotic market and were under enormous and well-publicized pressure, what would happen? What will happen? In this case the focus should be on ex ante rather than ex post. It would be an opportune time to consider and improve the evacuation of New Orleans before Hurricane Katrina arrives.

"When we finally closed General Re's securities trading department, I felt like it was out of a country song when it went away: 'My wife ran away with my best friend, and I miss more. More of my friends than my wife.'”

The above passage is a passage after Buffett closed the General Re insurance contract in 2005. It can be said that Buffett’s investment was a failure. His experience and lessons are that once the investment encounters unpredictable risks, Never love to fight.

The so-called risk refers to the possibility of suffering loss or damage.The risk of the stock market is the possibility of loss of investors' income and principal.There are two main types of risks in the stock market: one is the possible loss of the investor's income and principal; the other is the possible loss of the investor's income and the purchasing power of the principal.

In a variety of situations, investors may suffer losses in income and principal.For stock holders, when the issuing company suffers a loss due to poor management, or fails to achieve the expected investment results, the investors who hold the company's stock will have a reduced distribution of income, and sometimes there is no profit to share , investors will not get any dividends at all; after investors buy the stock of a certain company, due to some political or economic factors, most investors are pessimistic about the company's future prospects. Should be sold in large quantities, the company's stock price plummeted, and investors had to sell at low prices. In this way, investors bought at high prices and sold at low prices, resulting in losses of principal.For bond investors, the bond issuer has determined the interest of the bond when selling the bond, and promises to repay the principal and interest when it matures. However, not all bond issuers can perform their debts according to the prescribed procedures.Once the debt issuer falls into financial difficulties or does not manage well, and fails to pay interest and repay the principal as required, or even completely loses solvency, investors will inevitably suffer losses in terms of income and principal.

The investor's income and the loss of purchasing power of the principal mainly come from inflation.When prices rise sharply and inflation occurs, although investors' nominal income and principal remain unchanged or rise, as long as the growth rate of income is less than the increase in prices, the purchasing power of investors' income and principal will be equal. Will fall, inflation erodes the real income of investors.

From the perspective of the source of risk, securities investment risk can be divided into enterprise risk, money market risk, market price risk and purchasing power risk.

From the perspective of the relationship between risk and return, securities investment risk can be divided into two types: market risk and non-market risk:
1. Market risk
Refers to the risk associated with overall market volatility, which is the change in security returns caused by factors that affect the prices of all similar securities.Economics, politics, interest rates, inflation, etc. are all causes of market risk.Market risk includes purchasing power risk, market price risk and money market risk.

2. Non-market risk

It refers to the risk that has nothing to do with the fluctuation of the whole market, and it is the part of risk unique to a certain enterprise or a certain industry.For example, the impact of management capabilities, labor issues, changes in consumer preferences, etc. on security returns.Non-market risks include corporate risks, etc.

For industries with higher market risks, such as basic industries and raw material industries, their sales, profits, and securities prices are related to economic activities and securities market conditions.Industries with higher non-market risk are those that produce non-durable consumer goods, such as utilities, communications, and food.

Since market risk is associated with fluctuations in the entire market, no matter how investors diversify their investment funds, they cannot eliminate and avoid this part of risk; non-market risks have nothing to do with fluctuations in the entire market, and investors can eliminate this part through investment diversification risk.Moreover, there is a positive correlation between market risk and investment income. Investors who bear higher market risk can obtain income compensation that cannot be obtained by corresponding higher non-market risk.

In the western modern financial asset portfolio theory, the division method of market risk and non-market risk has been widely adopted.In order to more clearly identify the differences between these two types of risks, the following table lists the definitions, characteristics and types of risks involved in market risks and non-market risks.

Comparing Market Risk and Non-Market Risk

Market risk Non-market risk

Define the risk associated with overall market volatility Risk not related to overall market volatility
Feature (1) is caused by common factors.

(2) Affects returns on all securities.

(3) It cannot be resolved by diversifying investment.

(4) Related to securities investment income. (1) Caused by special factors.

(2) Affect the return of a certain security.

(3) It can be resolved by diversifying investment.

(4) Irrelevant to securities investment income.

Types of risks involved

(1) Purchasing power risk.

(2) Money market.

(3) Market price.

(4) Enterprise risk, etc.

Investment motto:

For ordinary investors, they may encounter unpredictable risks on the road of investment. At this time, most investors seem to hold a glimmer of hope, but it is this bleak hope that makes them sink even deeper. .In fact, the correct approach at this time is to resolutely withdraw no matter how painful it is to cut the position.If Buffett hadn't withdrawn at that time, he might not have been able to withdraw after the outbreak of the "subprime mortgage crisis" in 2008.

(End of this chapter)