Definitely the most important thing when it comes to investing is understanding risk. There is risk in every decision in our lives. We live in this world of uncertainty and how do you deal with that?
In finance you basically say risk is how far your possible outcome is from what you expect. (Also we base future risk on the past, which obviously has its flaws). The expectation is a straight line, so obviously futures returns don't land on the line that is our estimate. This reasoning is obviously inherently flawed because it is saying you expect something in the future, and you expect one of the multiple possibilities to be what happens all the time. Unless you have some skills I don't know about, I can't see how we can know the future.
So how should you think about risk?
Quite simple really, it is the chance of failure. Why are people afraid of risk, because they are scared of failure. When investing there is always a chance you will "fail", in other words, lose your money. Risk management is about limiting your chance of failure. Buffett's rule "Don't lose your capital." Simple but relevant. I think the vast majority of professional investors, at least the ones I know, understand Beta is flawed as a measure of risk and don't use it.
I think one of the most underrated sections taught is failure prediction. If you had to simplify wealth generation: "You invest money, provided you don't make loses, the money grows and grows and due to compounding you become very wealthy."
Surely the key in the above is "don't make loses". This is why failure prediction is important. As we need to understand, what are the indicators of possibly failure? If you are sure a firm can't fail, can you really go that wrong? There are models one can apply like Altman's Z score to predict failure.
Although as with investing, determining the likelihood of failure, shouldn't be rocket science. As with everything in finance the general idea is simple, will this company succeed or not.
When people think investing, there is this perception that finance is about the numbers. Doing a calculation getting to a price or a range. If this were true how could there be so many different ways of doing valuations? Also how can there be so many drastic stock movements?
I lecture financial analysis and portfolio management, the students (who are working) often ask, regarding the exam: "It will be mainly numbers right?", or if I ask the class what is the point of a DCF valuation, they say to get a price for a share.
One of the hardest things when you start investing is knowing what price to buy at and knowing what price to sell at. The idea that you can build a model to price a stock and it is accurate, is saying you can predict the future.
So why build a model and what does this have to do with risk?
Model building is a process whereby you have to understand the business. Prof Carlos Correia (who is a big believer in failure prediction), has done several valuations for litigation as he is considered "an expert on valuations". He has done this for massive international companies in multiple industries, as well as, smaller companies. As his starting point he claims to spend about two weeks researching the industry and business, before he even starts with the numbers.
Only once you have an understanding of the big picture, can you understand how the company fits in. So then you build your model, (model building seems tedious at first but the more you do it the more you learn and the more you want to know) it is actually about building an understand of what drives the business. As a model as only as accurate as the assumption (remember never perfect), and every assumption requires research.
At the end of the model building process; 100 hours or sweat, reading and a well worn keyboard later, you have a work of "excel art". I say art because it is your interpretation of the world, and you get a number which is to be honest is a decent guess at best.
One thing to be aware of, is you spend a lot of time doing a model and it becomes a little addictive, you just keep working on it, changing small things, reading something new etc. You invest a lot of time, and there is always a temptation to make the assumptions that give you the outcome you want. I remember sitting in a masters valuation project presentation in 2013, where a student had chosen a Dairy company, "Clover". His dad owned a dairy farm, and he built a good model. He recommended a strong buy based on certain assumptions (bullish). At the same time I was analyzing a dairy farm investment proposal, so was very familiar with the industry. When questioned, he was almost offended that I thought it wouldn't do well. He had invested time, and the success of the company was personal, and thus he was biased in his modelling assumptions. clover is the same price today four (4) years later. Don't forget you can make a model equal whatever number you want, but don't believe it, or fall in love with your piece of art.
This is where risk becomes key!
The most important thing is building a model is not the number but doing a sensitivity analysis (vary the individual assumptions one at a time and check the impact on your price). What this does it allows you to identify "the variables" or "drivers of success or failure" which are key to business. You then need to make sure those assumptions are accurate and well understood. As the RISK is that you get those assumptions incorrect. The real risk is in not understanding the business because you have not done the required research.