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117 - What risks are you willing to underwrite?

The DIY Investing Podcast

Release Date: 06/21/2021

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More Episodes

Mental Models discussed in this podcast:

  • Operational Leverage
  • Risk Management

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If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience. 

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Twitter Handle: @TreyHenninger

YouTube Channel: DIY Investing

Support the Podcast on Patreon

This is a podcast supported by listeners like you. If you’d like to support this podcast and help me to continue creating great investing content, please consider becoming a Patron at DIYInvesting.org/Patron.

Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode117

Business Risks

  • Stock specific
  • Acceptable:
    • Price - I'm willing to compromise on my price target of less than 10x earnings in recent days. Now I'm willing to accept up to 15x earnings per share for high-quality businesses
    • Growth Rate Estimates - I'm willing to accept being wrong on my estimate of growth. I'm usually targeting businesses that grow revenue/earnings at double-digit rates. If my pricing is right, I can be wrong on my growth rate assumption and still do fine.
    • Operational Leverage - I'm willing to bet on and be wrong about operating leverage
  • Unacceptable:
    • Balance Sheet Liquidity - I want a liquid cash-filling balance sheet
    • Self Funded - I don't want to buy a company that has to be funded by debt
    • Bankruptcy Risk - No bankruptcy risk of any kind, which means I am unwilling to accept highly leveraged companies.
    • Commodity Risk - I'm not willing to accept exposure to commodity prices. 

Portfolio Risks

  • Related to your overall strategy or investment portfolio
  • Non-stock or business-specific
  • Acceptable:
    • Illiquid stocks - I'm willing to accept lower liquidity in my stocks than other investors. I'm willing to spend months building my positions instead of just days or hours. 
    • Concentration Risk - I'm willing to hold fewer stocks than other investors. (3-5 companies)
    • Tracking Error Risk - I'm willing for my results to be dramatically different from the results of an index like the S&P 500 or the Russell 2000. 
  • Unacceptable:
    • Unwilling to underperform inflation for long periods of time. (5-10+ years)
    • Unwilling to underperform a 10% baseline absolute return over time
      • Brings in decisions like how to address cash drag
    • I have realized while preparing for this show that I don't really know what my "unacceptable risks" should e on a portfolio-wide basis. So let me know what I'm missing. You can send me an email or DM me on Twitter. 

Summary:

As an investor, the risks you take can be categorized as either business risks or portfolio risks. In order to earn a return, you must take some risks from each type. In other words, how are you willing to fail?