The Risk of Losses in Stock Investing: How Bad it Could be?

The risk of loss in stock investing is an integral part of the investing itself. Most investors, whether they are newbie or experienced, usually aware of the risks, but they are rarely paying attention to it. Every time I meet with fellow stock investors, they’re usually only like to talk about potential gains of their investments, without giving any word of the risk of loss that might be suffered. In essence, when an investor started to invest in stock, then it is the gain that comes to his mind, without any picture at all about how much the loss he may be suffered, or perhaps more exactly, he did not want to think about it at all! But it's perfectly humane, anyone willing to lose?

But in fact, one of the important keys for success in the stock market (either in trading or investing, but we’re talking about investing here) is the ability to measure the likelihood or risk of loss. This capability is needed, so that you can take steps to minimize the risk of such losses.

Because if you only focus on efforts to score maximum gain, then based on experience, the result will be bad. Just like playing football, if you only focus on the strategy to score as much as possible into the opponent's goal, without ever measuring how strong the ability of the opponent to score against your own, or in other words you are forgetting about the defense, then the result your team will lose. Remember that if you could score two goals, but the opponent is able to score three goals, then you will lose. Just as in the stock investment: If you made profit from some of your stocks, but the losses from the other stocks you held were bigger, then the overall results are still loss, are not it?

And the market (read: Jakarta Composite Index/JCI) is the opponent who can never be predicted. If it is in good mood (read: keep rising), then it was easy for anyone to make money. But if it was tumbled, then the investors who forget the strategy of this 'defense' will usually battered.

Well, I myself, in practice, I’m always paying particular attention to the possibility of a loss in any of my stock-buying decisions, or in other words before I buy stocks, I always take into account how much the value of the loss which could occur. However, until this article was written, I had had difficulties in explaining the method (to calculate the risk of loss) in an easy word. But fortunately, yesterday I saw an advertisement of insurance products, which may be used as a reference to measure the extent of losses that can be suffered by a stock investor.

So here it goes. August 2013 was the umpteenth time I got 'assaulted' by the market, which JCI is tumbling, so is my portfolio. That's when I started to think that if only I had an insurance company (because Mr. Buffett also has several insurance companies), then I will deliver protection against the risk of loss in investing in stocks. Because, just as you could have had an accident while driving a car or motorcycle, then in the stock market, no matter how great you are in investing, you still can lose at any time! Can’t you?

But then I think again, what kind of insurance products we’re talking here? Because:

1. The risks of investing in stocks is much greater than the risk of having an accident while driving a motor vehicle. You could drive the same car for years without experiencing any collision at all, but you almost certainly will suffer a loss (excluding the gain which also earned) in your investments in stocks, whether it's in the first year, second year, or so on, in addition to that the stock market itself is always experiencing a period of bearish, almost each year.
2. These risks will be greater if you are not a professional investor. Professional investors are those who are making stock investment activities as their job, as their livelihood! Lik fund managers, or full time individual investors (like Mr. Lo Kheng Hong). Professional investors generally understand about what he did, whether it was buy, hold, or sell stocks, because it was his job, so he had enough time to study or analyze the fundamentals of the stock he holds. Unfortunately the majority of retail investors in the capital market are not the professional ones, but only making their stock investment as a sideline activity outside his actual job.

In essence, it was almost impossible to build an insurance product that can cover the risk of loss in stock investing, as the risk is very high.

But apparently there is an insurance company that is able to capture these opportunities, and is also able to design an insurance product which on one hand will protect its customers from the risk of loss in investing in stocks, but on the other hand will abe to provide benefits for the insurance company itself, as the risk is limited. I will not mention the name of the insurance company, as well as the name of the product, but the descriptions of the product offered are as follows:

First. Stock investment that is protected is the stock investment through unit-link, where you bought stocks through an insurance company. By the insurance company, your funds will be placed in the mutual fund, so your fund will be managed by a professional fund manager. In this way, the risk of loss due to lack professionality will automatically eliminated, because your funds are managed by professionals, not by your own.

Because your fund is now managed by investment professionals, then the biggest risk is relatively limited to the fluctuations of the market, in this case the JCI. If JCI is down, then usually the net asset value (NAV) of your unit-link will also go down.

Second. Value of the guarantees is only amounted to 80% of the value of the highest NAV ever achieved, not 100%. This means that if you buy this insurance product, then when the market fell 30% from its peak position, and your NAV is also collapsed by 30% to make your investment value become only 70% from its peak position, then you have the option to claim the guarantee, where the value of your investment does not fall to be only 70% from its peak value, but 80%.

For illustration, first you join this insurance product. Then, you buy an unit-link at the price of Rp2,250 per unit when JCI was at 4,500. Some time later, JCI rose to 5,000, and your unit-link is now worth Rp2,500, aka scored 11.1% of gain.

But some time later, JCI turned down from 5,000 to 3,800, aka down 24.0%, and your unit-link value also fell by the same percentage, which is down from 2,500 to 1,900. So now you have an option to sell your unit-link at a price equal to 80% compared to the position of the highest NAV ever achieved, aka 2,500 x 80% = Rp2,000 per unit.

Thus, even though you are actually still lose, but the lose is smaller than the actual, because you could sell your unit-link at the price of 2,000 instead of 1,900. The difference of Rp100 was covered by insurance companies, as a form of ‘protection’.

Conclusion

I only took a few seconds when reading the description of the above insurance product, to be able to jump to the conclusion that this is an insurance product that answers my question about the insurance products which on the one hand can provide protection to investors, but on the other hand still provide substantial benefits for the insurance company concerned.

Because, remember that although JCI could go up and down all the time, but to be down by more than 20% from its peak, then it is rarely occur, most often only once or twice a year during the period of the bear market. And yet the insurance product only guarantee 80% of your investment value, not 90% or 100%. Okay, there are also cases where the stock market fell as extreme as in 2008 and 1998, but it occurs more rarely, perhaps only once in ten to fifteen years.

That's why, when the risks of investing in the stock could be limited to market risk (by buying shares through unit-link), while the value of the coverage is also only 80% of the value of assets covered (not 100%), then the risks faced by insurance companies could be far lower, even if compared to conventional insurance products. If you insure your car for protection against the case of losing, and the car's price is 30 grand, then when the car was completely lost, the losses suffered by the insurance company is also 30 grand.

While this insurance for stock investment (again, the investment through unit-link), when the NAV of your unit-link down from Rp2,500 to Rp1,900 per unit (like the example above), then the value of loss that is borne by the insurance company was only Rp100, aka very small! Plus, remember that not all investors will immediately sell their unit-link when the NAV of unit-link itself was plummeted, but some of them will choose to hold it, because they know that in the end, the NAV will rise again, when the JCI recovered.

So if the customer does not redeem the units of the link, then the insurance company did not need to pay the cover, did not it? I believe one hundred percent that the insurance company must has been educating its agents to persuade their customers to not redeem their unit-link when the market was plummeted, usually with this magic sentence: 'Calm down Sir! Your investment is not going nowhere but will later recovered! Just sit and wait.'

So you can imagine how big the profits for the insurance company when they successfully sell this product of insurance, because as the stock market will eventualy rise, their insurance coverages are almost zero! Of course, they also could have to bear an extremely loss if there is a crisis like in 2008 or 1998, when the words 'Calm down! This is only temporary!' from insurance agents may no longer be heard by customers who are already panicked. But please, how often the market tumbled like that???

It’s Relation to Out Investment in Stocks

The above examples illustrate how big the risk of loss that must be faced by insurance companies, when they have to deal with the 'uncertainty in stock investing '. Yep, nothing is certain in the stock market, including no one knows when stock index will rise or fall, and that becomes the risk of loss for every stock investors. But for insurance companies, after going through several strategies, the risk can be reduced to as low as possible.

But based on illustration of the risk management as already discussed above, you might able to estimate the worst scenario that could happen to your stock portfolio, and I will explain it here:

First. It is a common knowledge that if the JCI (and also any other stock index in other country) dropped of about 20% from its peak, it was called the bear period, and it is routinely occurs every one, two, or three years. If the decline reached 30% or more, then you could say that s**t is getting serious aka crisis, but it only occurs every ten to fifteen years. At the peak of the bear market of last 2013, JCI did not decrease to more than 30% (from its peak position of 5,251), but only about 27%.

This means that if you buy stocks that move in line with the movement of the index, which is (though not always) blue chip stocks with good fundamentals, the the worst losses you can suffer is approximately 20%, if you acquired your stocks when the market was at its peak position.

And that means, if your asset (in stocks) is worth US$ 10,000, for example, then as long as you do not use margin and you only choose stocks that follow the movement of the market, then you don’t have to imagine that your asset will run out at all. The worst case that could happen is you lose about US$ 2,000, so the remain asset is still quite large, ie US$ 8,000.

And in investing, that is an acceptable risk, because the potential of gain is far greater! Your asset may decrease about 20% for the worst case, but also may gain 50%, or even 100% or more, if you’re doing well over time. But the point is, there is no reason to panic when your stock goes down, because your asset is not run out entirely, but only about 20% of its initial value, and even that’s only happen when the market was fall (unless of course, if you buy bad, penny-crap stocks, and the like).

Second, the insurance company that we’ve discussed above know very well that no matter how deep the market could tumbled, yet it will ultimately rise again over time. That means, when you are having a bad luck as you’re entering the market when the JCI was at its peak, then even though your portfolio become red colored by the market correction that occurred later, but in the end your stocks will rise when the market recovered. In this situation you are required to be able to see a decrease in the market as an opportunity to buy more stocks at lower prices, instead of panic and then sell your stocks! If you are able to 'survive' when the market is getting hit by 'storm', the your risk of loss may be reduced significantly.

However, remember that the risks above did not take these account:

1. The factor of ignorance. Most of retail and amateur investors in this country know absolutely nothing about the stocks they buy, and
2. The factor of greed and fear. Most of investors are prone to euphoria (so they are sought to buy more) when the market is bullish, or experiencing panic (so they are selling) when the market is bearish.

Other than those, remember also that the risks discussed above is just a market risk, not including corporate risk. Market risk is the risk of loss due to the decrease in stock market, or a decrease of price of the stock you hold due to negative sentiment or something. While corporate risk is the risk of loss due to a fundamental change of the stocks you hold. Suppose you hold a stock for good fundamental, where the company had a big net profit, etc.. But over time, the company was experiencing a decline in profits, or even losses. Then, in that situation you will suffer a loss when the stock price plummeted.

To the risk of loss due to ignorance, it can be minimized with the following tips: Never buy a stock without a depth analysis over the company. Never, I said never! Buying stocks based solely on the information that it will be rise by a good news or something.

And due to the factor of greed and fear, it can only be minimized by extending the experience. My bottom line is, if you are new in the market and still having some dizzy when the market was dropped, then it's reasonable. But if you have many years in the market but still having the same thing, then you can consider to open an account of mutual fund.

As for the risk of losses due to corporate risk, as already discussed above, the only way to minimize them is to apply the method of value investing, which is to buy stocks only at price that is significantly lower than the fair or intrinsic value.

In the end, the risk of loss is already a 'daily diet' for a stock investor. No matter how good you are in analyzing and stock picking, but still, in the end you will experience a loss from certain stocks. The point here is, you do not need to be discouraged when at a certain time you have a loss, especially for those of you who are new, because what is important is that after a long period of time, the accumulation of profit you earn is greater than the accumulated loss you suffered.

But most importantly, as discussed above, you now have an idea of ​​how much loss you may suffer, which is only about 20% if the market was bearish. Once again, even though you are still lay about investing, but never imagined that your fund will run out completely.

While on the other hand, the potential profits that can be achieved is much greater, which can reach hundreds of percent, or many times over! Although you are certainly will not be able to earn that profit in an instant of time. If you do not believe, then try to check the increase of price of stocks with good fundamentals like ASII, BBRI, BMRI, CPIN, SMGR, and so on, in the last five years.

So, still afraid to come to invest in stocks? I hope not :)