Navigating the Risks and Rewards of Investing in Stocks

Imagine you are at a children’s birthday party hosted by your boss. There is a game set up where an urn (see image below) is kept on a table. The urn has two coloured balls – red and black. Red balls are seven, and black balls are three.

The game is to draw three red balls in a row, and the winner will get an extra-large chocolate. Being good at math, you know that the probability of drawing a red ball is 70 percent. Your confidence level shoots up, and you start drawing. The first ball comes out black, and you feel disappointed. You draw another ball; it is again black. Now you become angry and draw another. It is again black.

You think it is such an unlucky day because all three balls in the urn have come out when you were drawing. Just as you are about to leave, you think of drawing another ball to see how the red ball looks to make yourself feel better.
As you draw, you have another black ball, and then you pick up the urn from the table. The urn is hollow from the bottom, and the mischievous child was putting more black balls. All your probability estimates become insignificant.

The same effect takes place in the stock market. The stock market is a world full of excitement and adventure, but it’s also a world full of risks and challenges. There are many mischievous children, and you may not know which colour ball will come out of the urn (above example is taken from the book- Fooled by Randomness by Nassim Nicolas Taleb).

Thus, in this article, we would guide you with two basic principles. The first principle is for risk – margin of safety, and the other is for reward – being a contrarian. Let’s start:

• Margin of Safety: This concept lies at the heart of investing. It is the cushion of protection that investors seek to build into their portfolios, a buffer against the unpredictable and often volatile nature of the stock market.
  The margin of safety can take many forms, but it is essentially the difference between the price you pay for a stock and its estimated intrinsic value. In simple words, if you estimate a company’s value as ₹100 from your analysis, you will pay ₹80 to buy the company to practice margin of safety.By demanding a margin of safety, investors are protecting themselves against the possibility of a company’s underlying fundamentals deteriorating or the market sentiment shifting against them. It’s a way of ensuring that even if the worst-case scenario happens, the investor still has a safety net to fall back on.In the end, the margin of safety is not just a practical tool for investing, it’s a mindset. It’s a way of approaching the stock market with a conservative approach and knowing that you may not know everything about the markets or the stock you will purchase.
• Being a Contrarian: It is a common saying among investors who invest in start-ups, as seen on shows like Shark Tank India, that investors are generally sheep and not sharks. Average investors tend to follow a herd approach by buying stocks that are popular and in trend.Contrarian investors are a different breed and class. They are willing to take positions in stocks or sectors that are opposite to the prevailing market sentiment. They are willing to bet against the crowd.It’s a strategy that Howard Marks, the legendary investor, and founder of Oaktree Capital Management, has become famous for. Marks believes that the key to successful investing is to identify mispricing in the market – instances where the price of a stock or security does not reflect its true underlying value.
  

  “The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and price is high).”- Howard Marks

  Being a contrarian investor requires a willingness to go against the trend and to think independently. It’s a strategy that can be challenging but potentially rewarding, as it allows investors to identify misprises in the market and capitalize on them.

  Therefore, we encourage our readers to follow these two principles when embarking on their treacherous journey of investing in stocks. As the world is full of randomness, there is always a mischievous child around the corner to prove you wrong about your decision. We hope that you make wise decisions and have good fortune on your side. Happy investing!