Risk isn't just "the price might fall". It's the chance the business or your thesis is permanently impaired. Measuring it well is what keeps a portfolio alive through bad years.
Two very different kinds of risk
- Business risk — the company's earnings prove fragile: cyclical demand, customer concentration, obsolescence, too much debt.
- Price (market) risk — the quoted price swings even when the business is fine. Often measured by volatility or beta (sensitivity to the overall market).
Balance-sheet warning signs
| Metric | What it flags | Rough comfort zone* |
|---|---|---|
| Debt / Equity | How leveraged the firm is | Lower is safer; varies by sector |
| Interest coverage | Can profits cover interest? | Higher is safer (e.g. >3×) |
| Current ratio | Short-term bills vs. short-term assets | Around 1.5–3 |
*Rules of thumb only — capital-intensive sectors like utilities safely carry far more debt than software firms.
Example: a company earns $200m of operating profit and pays $40m of interest, so interest coverage is 5×. If profits halved in a recession it could still pay its lenders — a comfortable cushion.
Diversification: the only free lunch
Spreading money across uncorrelated businesses reduces the damage any single mistake can do, without necessarily lowering expected return. It doesn't eliminate market risk, but it tames company-specific risk.
