Mental Models discussed in this podcast:

• Operational Leverage
• Risk Management

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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?