3 ways to lower your sharemarket investing risk

You can never eliminate risk in investing. The best we can do is plan for those risks we can reasonably expect and avoid companies whose risks we can't get a handle on. If investing was easy, we'd all be on our super-yachts.

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In this space earlier this week, I outlined my reasons for taking a pass on the banks.

I'm not swearing off our banking sector forever, but I suggested that while current prices make the banking sector well worth a look, I wasn't sure that they were cheap enough to tempt me, given the headwinds currently facing the sector, and the inherent opacity of their books.

I have no reason to believe the bank bosses are being in any way irresponsible or taking unnecessary risks with shareholders' money, I just find it difficult to be able to assess the level of risk, both within the banks themselves, and increasingly with their counterparties spread around the world.

Following that article, one correspondent asked a simple question, namely:

'What is the alternative…What businesses are easier to understand, analyse and are less risky?'

It's a great question.

You can never eliminate risk in investing, so the questioner is right when asking about less risk, rather than no risk. The best we can do is plan for those risks we can reasonably expect and avoid companies whose risks we can't get a handle on.

Easier to understand…
The first part of the question is probably the simplest. The key question to ask is 'how does this company make its money?'

Banks take depositors cash, lend it to borrowers, and keep the differential between the two interest rates. So far, so good. To really get a handle on the business though, you'd need to know who they're lending to, how creditworthy the borrowers are, and how reliant their customers are on other financial institutions.

Contrast that with a company such as Domino's Pizza (ASX: DMP). The business model is pretty straight-forward. They rent stores, buy ingredients and turn those into pizzas that they sell for a little more than the price of the ingredients, labour and other costs. They also franchise stores, and pick up a cut of each store's sales.

Retailers are another example. As long as they keep their inventories under control, the operations are pretty simple to understand.

It's worth noting that 'easy to understand' doesn't mean 'always a great investment'… just ask those who bought Myer (ASX: MYR) shares in the float.

…to analyse…
I can't do justice to a topic as broad as investment analysis in one article – there are whole tertiary courses devoted to the subject.

There are a couple of starting points that can make your investing life easier, however.

The first point relates to the examples I just gave – there are no extra points in investing for 'degree of difficulty'. It's always much harder to analyse a business which has a complex structure, is in multiple categories or is in a highly technical industry such as banking or biotechnology where specialised knowledge is required. There's nothing wrong with just letting those companies go through to the 'keeper.

Secondly, look for businesses whose management team is candid about both the good and bad news. The ride might feel a little bumpier, but at least you're getting it straight.

Lastly, companies who have gone through structural changes or have made acquisitions can be tricky. Often it's hard to compare their financial statements from year to year to really get a handle on how the underlying business is performing.

…and are less risky
The Oracle of Omaha, Warren Buffett sums up risk beautifully in this short quote – "risk comes from not knowing what you're doing". Hopefully we've addressed that in the first two sections, above.

Buffett's quote can be applied to two key areas – business risk and investing risk.

The number one potential enemy of all businesses is debt. Used well, it can be an important source of growth funding, and can help businesses earn higher profits. Used recklessly or naively, it greatly increases the chance of a small setback becoming a company-threatening event.

It's very hard for a company with no debt to go out of business, and if it does, it happens slowly.

Investing risk comes from investing without doing your homework – from buying companies you don't truly understand, or whose business models are unsustainable, to simply paying too much.

Foolish take-away
If investing was easy, we'd all be on our super-yachts in the Bahamas or skiing St Tropez. Unfortunately it's not that simple. It can be incredibly rewarding, both intellectually and financially, if you are patient and invest in companies, not just stock symbols.

Investing is a game for the tortoises, not the hares – and you can avoid self-inflicted wounds by taking the time to really understand what you're investing in, and why.

Are you looking for more quality stock ideas? Motley Fool readers can click here to request a new free report titled The Motley Fool's Top Stock For 2012.

Scott Phillips is The Motley Fool's feature columnist. Scott owns shares in Domino's Pizza. The Motley Fool's purpose is to educate, amuse and enrich investors. This article authorised by Bruce Jackson.

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