Investment Risk
Ignore it at your peril!
Investment risk is a concern for all investors. Types of risk that can be encountered are many and varied and need to be understood if you, like me, prefer safe investing rather than high risk investing.
Risk for the value investor is automatically reduced if value investing protocols are followed. For example, investing within one's circle of competence is one way of reducing risk.
Providing for an adequate margin of safety minimises investment risk.
"It's not risky to buy securities at a fraction of what they're worth.” - Warren Buffett
Choosing stocks with characteristics such as a high return on equity, stable earnings per share growth, low historical price earnings ratio, low debt to equity ratio also allows risk to be managed.
Stocks having these features have been shown to rebound faster after market downturns and so provide an important means to manage stockmarket crashes.
Value portfolios have been proven to be less risky than the market as a whole when tested by 'non-conventional' but eminently sensible measures of risk such as how much a stock drops in reaction to bad news about its operations and the extent of price declines after stockmarket crashes.
Measures such as these are in tune with our common sense understanding of stock risks. Also, value investors treat price fluctuations as opportunities to buy and sell rather than a measure of the riskiness of stocks. They welcome volatility!
If the price of a stock halves in price, I ask myself does this make a purchase of its shares high risk investing?
The answer I arrive at is - not necessarily - because the margin of safety has increased if the intrinsic value of the stock is above the reduced price.
Be fearful when others are brave
And be brave when others are fearful!
Conventional measures of investment risk such as stock beta assume that stock risk is related to volatility. The greater the volatility in the stock price, the greater the risk.
But stock volatility has more to do with what two punters are prepared to trade a stock for at any point in time.
The notion of a margin of safety assumes that I acknowledge the existence of an intrinsic value for the stock and that I can confidently estimate it. A margin of safety has nothing to do with stock volatility.
Another aspect of investment risk is portfolio risk. This is usually related to diversification. That is, holding a sufficient number of stocks such that a downturn in any one of them is counterbalanced by the performance of the others.
Bruce Greenwald in his book Value Investing: From Graham to Buffet and beyond, suggests that rather than being precisely wrong by measuring investment risk using such measures as stock beta, you can get it approximately right when investing by considering factors such as ...
- the certainty or otherwise of the long tern economic characteristics of the business
- how well the management can be evaluated in their ability to realise the full potential of the business, to manage its cash flows and to demonstrate concern for shareholders
- the purchase price of the business
- the level of taxation and inflation likely to be experienced and the effect of these on the shareholder's net returns
Another type of investment risk that value investors and others need to contend with is market risk. At times, Mr Market gets over exuberant and prices head north.
One strategy to insure against an unpredictable market crash - and they are all unpredictable - is to take out insurance by short selling high priced shares, or by short selling the market index to get some general insurance. This offers some protection, at a cost, if the market drops.
Stop losses and guaranteed stop losses perform a similar function for individual shares, again at a cost. These strategies are more commonly employed by day traders and CFD traders rather than by long-term investors.
Value investors can detect overvalued markets either by being able to calculate that there are less and less stocks offering fair value, or by detecting that price/earnings ratios are at or above historical annual average values.
Of course, keeping an eye out for a flood of newcomers to the market, attracted by the overall exuberance, is another tell-tale sign.
These are some of the clues that make me start retreating to cash by part-selling or selling high risk stock. The cash can be used to reduce any portfolio leveraging and/or to build up a nest egg to purchase the bargains that inevitably follow a major downturn.
While no one rings a bell to signify the top of the market, value investors have the means to better understand when it is time to start moving to cash.
They are also cushioned by a margin of safety even if they are still partly invested.
Stock market risk and the pain of loss go hand in hand. For most of us, the learning experience provided by a large fall in the stock market and the resulting pain etches the experience firmly in our cerebral cortex.
This is the way we learn to fully appreciate investment risk!
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