Investing Risk

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Risk is uncertainty. Investing risk is distinct from the risk one may take in a game of chance.

In games of chance the odds are known beforehand. The probability of success and failure is known.

Investing is different. There is no way to know all possible outcomes ahead of time. There is also no way to know the probably each outcome will occur. These characteristics make investing risk impossible to quantify precisely.

The 8 Rules of Dividend Investing include both stock price standard deviation and beta. These are both proxies for risk and not risk in itself. Real risk is permanent loss of capital. Sure Dividend uses these measures because they have historically increased returns with less price volatility.

Risk & Return

Rational people don’t take investment risk for the thrill. All things equal, less risk is better than more risk. Riskier investments should provide higher returns. In reality, there is no hard rule that higher risk means higher returns.

Think about Russian roulette. It is very high risk, but the return for winning is the same as the return for not playing – you keep your life. The extremely high risk of Russian roulette is not compensated with high returns. Russian roulette is a fool’s game.

Perceived risk should always be compared to expected return. The higher the expected return, the higher amount of risk is acceptable. Imagine a coin flip game. It costs $1 to play. A ‘heads’ gives you $3. A ‘tails’ means you lose your investment. This is a very high risk investment; there is a 50% chance you lose your investment. It is also an exceptionally profitable investment worth taking every time.

Portfolio Allocation & Risk

The Kelly Formula finds the optimal bet size to maximize wealth for games where all odds and possibilities are known. The stock market is not the place for the Kelly Criterion.

Simple portfolio management rules are better in unknown environments. Investing 1/n of funds in each holding – also called ‘equal weighting’ is a simple and effective heuristic to use for portfolio diversification. The equal weight S&P 500 index fund RSP has significantly outperformed the market capitalization weighted S&P 500 index ETF SPY over the last decade.

Equal weighting can be expensive for individual investors with many positions. Investing an equal amount at the outset of an investment and letting the winners run works well while minimizing transaction costs.

Types of Risk

There are multiple types of risk. Investing in publicly traded businesses exposes investors to two primary types of risk: price risk and business risk.

Price risk is the risk associated with paying too much. Coca-Cola KO is a high quality businesses. That doesn’t mean investors should expect to see high returns if they buy Coca-Cola stock at a price-to-earnings ratio of 50.

When a business’ cash flows are projected far into the future with very high growth rates it is priced for perfection. If everything does not go perfectly investors will see losses as expectations about the stock revise downward causing the stock price to fall. It is unquestionably rare for events to unfold as planned.

That’s why investors should demand a margin of safety when purchasing stocks. A margin of safety is paying a price below what you believe fair value to be – just in case things don’t work out exactly as planned.

Business risk is the risk the underlying business of a stock will decline or go bankrupt. Business risk is associated with 3 items:

  1. Pace of industry change
  2. Strength of competitive advantage
  3. Leverage

Businesses with little or no leverage in slow changing industries that possess strong competitive advantages have the lowest business risk. These are the types of businesses the Sure Dividend plan seeks to invest in.

Slow changing industries help preserve competitive advantages. Insurance is an example of a slow changing industry. The insurance industry operates largely the same way today as it did 200 years ago. Technology does not cause obsolescence in insurance the same way it does in the tech industry.

Strong competitive advantages are critical for sustained business success. Businesses with strong competitive advantages will be able to consistently grow faster or be more profitable than their peers. Industry leaders tend to have strong competitive advantages.

Leverage amplifies gains – and losses. The more levered a business, the less flexibility it has to navigate the uncertainties of the world. An unlevered business with cash on hand can withstand occasional losses. A highly levered business cannot and may be forced into bankruptcy by just one or two difficult years.

Time Risk

Individual investors have an additional risk to consider; time. Some individual investors must regularly liquidate their holdings to live off the proceeds. This causes investing to becomes much riskier.

This is a timing risk. When you need cash flows at specific times, you are forced to sell for reasons beyond what would maximize returns.

As an example, you may be forced to liquidate stocks in March of 2009 – at the worst possible time – in order to generate cash flows for lifestyle purposes. Investors in this situation should look for a well-balanced portfolio that seeks to reduce price volatility while still providing returns. Being forced to sell at any given time is a risk that amplifies the potential of a permanent loss of capital.

Risk & Bull Markets

Risk increases during bull markets. The higher the price of the overall market, the more risky the market.

Few would argue that it is better to invest in the market when the S&P 500 has a price-to-earnings ratio of 40 than when it has a price-to-earnings ratio of 15.

Sadly, the better the market performs, the less risky people believe an investment is. Too many investors believed that ‘internet stocks are a sure thing’ and ‘prices will continue to rise’ in 1999.

At the same time, people tend to become most fearful when the market is falling. When people panic sell, it creates opportunities to improve your dividend stock portfolio by buying high quality businesses at a fraction of their fair value.

Warren Buffett perfectly captures the preferred investor mentality with this quote:

“be greedy when others are fearful and fearful when others are greedy”

Contrary to popular opinion the market is less risky when investor sentiment is low. It is most dangerous to invest when investors think the market has reached a “permanently high plateau” as economist Irving Fisher famously said just prior to the beginning of the Great Depression in1929.

Black Swans

Risk in general is difficult to quantify. Black swan events take this difficulty to a new level. Black swans are one-time events that occur rarely and are therefore very hard to predict. A black swan event can befall any business.

Black swans are unpredictable and carry enormous consequences. Black swans can derail even great businesses. Diversifying your portfolio across multiple businesses and industries is the only way to limit the impact of unforeseeable black swans.

The Folly of the Rear View Mirror

When we look back on any investors record, we see only one version of what could have happened. An investor can ‘get lucky’ and make bets with poor probability adjusted expected returns and still do well. Buying lottery tickets is a terrible idea, but there are millionaires created from the lottery. It doesn’t mean buying lottery tickets is a good investment decision.

An investor could have bought a penny stock that tripled in value. The same stock could have a 98% chance of failure. The investor just gets incredibly lucky. They look back on this investment and think it represents some sort of exceptional skill, when it doesn’t.

Making excellent investment decisions and having bad luck is the other side of the equation. The same investor could have shorted the penny stock with the 98% failure rate and looked like a fool when the stock went up. This investor made the right investment, but realized very poor results.

Over time luck is replaced by skill. Any one investment is heavily influenced by luck. Similarly, the returns of any one year are significantly influenced by luck. Investors with long track records – like Warren Buffett – have proven they can invest successfully over decades. The significance of luck in investment results declines over time.

Risk is very difficult to look back on. If you did well on an investment, was it risky? It could have had a 90% failure rate, but you got lucky.

Further Reading

The ideas for this article are woven together from great thinkers in other books listed below. The key idea in each book is listed next to the title and author.

Luck vs. Skill: The Success Equation by Michael Mauboussin
Black Swans: The Black Swan by Nassim Taleb
Margin of Safety: The Intelligent Investor by Benjamin Graham
Kelly Formula: Fortune’s Formula by William Poundstone
1/N Weighting: Risk Savvy by Gerd Gigerenzer
Several Concepts: The Most Important Thing Illuminated by Howard Marks

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