Uncover the Real Risks: Dive Deep with the Fishbone Diagram

[i4value]

If you want to manage risk, you first have to identify all the causes of investment risks. It is very sad to say that there is a lot of muddled thinking out there.

For example, I have come across an article that described 4 ways to mitigate risks. It then went on to cover diversifying into different sectors, countries, market capitalization, and styles. To me, it was only one measure i.e. diversification.

Many people also confuse between cause and effect. Some of the recommended risk strategies don’t address the root causes.

This is where the Ishikawa or fishbone diagram came in. An Ishikawa diagram shows the causes of an outcome and is often used in manufacturing to show where quality control issues might arise.

It is sometimes referred to as a fishbone diagram.  It resembles a fish skeleton, with the "ribs" representing the causes and the final outcome appearing at the head of the skeleton.  In such a diagram:

• The head of the fish is created by listing the problem and drawing a box around it.
  
• A horizontal arrow is then drawn across the page with an arrow pointing to the head. This acts as the backbone of the fish.
  
• The key causes are identified that might contribute to the problem. These causes are then drawn to branch off from the backbone with arrows, making the first bones of the fish.
  
• For each key cause, the root causes of the problem are identified. These contributing factors are written down to branch off their corresponding key cause.
  

I consider risk as permanent loss of capital. To suffer a permanent loss of capital, the investment has to be sold at a price that is lower than the buying price. 

For simplicity, I will ignore the situation where the investment has been sold due to short-term volatility.  From a value investment perspective, this is unlikely to happen.

To help identify the root causes, I have used the Ishikawa fishbone diagram to help identify the various causes and effects as shown in the chart below.



I assumed that any sale is because the price is “permanently” below the purchased price due to the following direct reasons:

• Deterioration in the intrinsic value due to changes in the fundamentals - both macro and micro.
  
• Issues with portfolio construction.
  
• Wrong assessment of intrinsic value in the first place.
  
• Stock market changes due to regulatory changes.
  

These are the main direct causes and there are other root causes for each of them.

If you want to know more go to “How to mitigate permanent loss of capital in an awesome way”