The way I see it there are three sources of risk when investing. The first is the company whose shares you’re buying, the second is Mr Market and the third is you.
Company/Business risk
This is the risk that the company either doesn’t pan out the way you thought, or it goes bust or gets taken over or does something stupid that permanently damages the intrinsic value of the business.
You have some control over this and basically this is what all the analysis effort goes into. How will it do, what will the profits be more or less, will it keep trading through your holding period, will that catalyst appear; those sorts of issues. For bottom-up value investors this is what it’s all about.
Market risk
This is Mr Market’s speciality. It’s basically the risk of making a loss due to a change (downward) in the share price or of the portfolio as a whole. To most value investors this is utterly irrelevant, or at least it should be. Mr Market is there to serve you and not to guide you and the basic premise of value investing is that Mr Market makes a lot of mistakes and that basically he’s either a bit stupid or mad or both. He’s definitely not the sort of person whose opinion you want to listen to.
Value investors come to their own independent conclusions about the likely value of a business by doing fundamental research. If Mr Market offers them an opportunity to buy it at a significant discount from that value then they’ll take him up on his offer.
If he subsequently decides that the company is worth only half what it was before and drops the share price by 50% the value investor is supposed to be even happier because there’s an opportunity to buy this asset at an even lower price. Of course, that’s assuming company risk hasn’t appeared and the company is actually worth less than it was before.
On its own though a falling share price means nothing and the market is efficient enough so that you really do have absolutely no way of knowing which way the share price is going in the next few days, weeks or months.
The real risk of market risk is that it can cause you to buy and sell at the wrong time which is known as…
