Ignore low risk stocks at your peril!
Safe investing as a means of minimizing investment risk is a concern for all investors.
The risk free interest rate provides the least risk (theoretically zero), and commonly refers to Treasury short-dated bonds in the relevant currency.
Types of risk that can be encountered are many and varied.
They need to be understood if you, like me, prefer safe investing rather than high risk investing.
The Meaning of Risk
Stock market risk can have different meanings for different people. It may be viewed as ...
- the volatility of an investment - stock beta is a term used to measure this
- the risk of a capital loss - my preferred meaning
- the risk of a drop of returns from a portfolio - a concern for many retirees
- For Warren Buffett "risk comes from not knowing what you are doing".
Risk for the value investor
is automatically reduced if value investing protocols are followed. For example, investing within one's circle of competence
gets me on the path to safe investing.
Providing for an adequate margin of safety also maximizes safe investing. This can be achieved by buying a stock below its calculated intrinsic value.
"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 are safe investing strategies.
Stocks having these features have been shown to rebound faster after market downturns and so provide an important means to manage stock market crashes.
The Importance of a Margin of Safety
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 stock market crashes.
Measures such as these are in tune with our common sense understanding of stock risks.
Also, safe investing means treating 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!
Risk and Volatility
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 most famous measure of volatility is the market volatility index of the Chicago Board Options Exchange (CBOE) called the CBOE VIX or the VIX index. It is sometimes referred to as the fear index.
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. But stock price volatility may create a margin of safety.
Diversification and Risk
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.
Diversification may, and should be extended further by holding a proportion of capital in other asset classes, particularly cash and bonds.
A popular strategy, at least until the recent global financial crisis, was to look for asset classes that were not correlated to movements in the stock market.
This has not proved to be a smart move as some asset classes unrelated to shares exhibited large falls in value during the downturn as well.
Whereas the expression cash is king has maintained its status - at least for the time being!
Global economic recession and depression certainly add to investment risk.
Bruce Greenwald in his book Value Investing: From Graham to Buffett 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 term economic characteristics of the business
- how well the management can be evaluated in their ability to realize 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 shareholders' 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.
At other times, an unpredictable event may occur signalling bad news, such as a so called black swan event. This may cause Mr Market to panic and head south!
Short Selling and Stop Losses
One safe investing strategy to insure against an unpredictable market crash - and believe me, 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.
Other Risk Indicators
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.
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.
Safe investing can mean holding a lot of cash when markets overheat.
The cash can be used to reduce any investment 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!
Types of risk - Given the range of stock risk investors and companies face over time, it is not hard to accept that there is no such thing as risk-free profit.
Stockmarket crashes - Stock market crashes need to be managed by long-term investors. Why? - because they will inevitably happen from time to time.
Stock beta - The usefulness of the stock beta risk measure decreases as your investment time horizon increases. How long is yours?
Stock market diversification - Stock market diversification is generally considered to be a sensible strategy. The question becomes how much diversification?
Global recession - What are the causes of economic recession and global recession?
Short selling - Short selling or shorting a stock involves the selling of stock that the seller does not own. Why do it?
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