Monday, 8 September 2008

Heuristic-driven biases: 5. Innumeracy

5. Innumeracy

People have difficulty with numbers.

Trouble with numbers is reflected in the folowing:

People confuse between "nominal" changes (greater or lesser numbers of actual dollars) and "real" changes (greater or lesser purchasing power). Economists call this "money illusion".

People have difficulty in figuring out the "true" probabilities. Put differently, the odds are that they don't know what the odds are. To illustrate this point, consider an example. In a lottery in which six numbers are selected out of fifty, what are the chances that the six numbers will be 1, 2, 3, 4, 5, and 6? Most people think that such an outcome is virtually impossible. The reality, of course, is that the probabiliy of selecting 1 through 6 is the same as the probability of selecting any six numbers.

People tend to pay more attention to big numbers and give less weight to small figures.

People estimate the likelihood of an event on the basis of how vivid the past examples are and not on the basis of how frequently the event has actually occurred.

People tend to ignore the "base rate" which represents the normal experience and go more by the "case rate", which reflects the most recent experience.

Heuristic-driven biases: 4. Aversion to Ambiguity

4. Aversion to Ambiguity

People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes.

In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.

In the world of investments, aversion to ambiguity means that investors are wary of stocks that they feel they don't understand. On the flip side it means that investors have a preference for the familiar.

This is manifested in home country bias (investors prefer stocks of their country), local company bias (investors prefer stocks of their local area), and own company bias (employees of a company have a preference for their own company's stock).

Heuristic-driven biases: 3. Anchoring

3. Anchoring

After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.

Suppose that investors have formed an opinion that company A has above-average long-term earnings prospect. Suddenly, A reports much lower earnings than expected. Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the compny is above-average and will not react sufficiently to the bad news. So, on the day of earnings announcement the stock price would move very little. Gradually, however, the stock price would drift downwards over a period of time as investors shed their initial conservatism.

Anchoring manifests itself in a phenomenon called the "post-earnings announcement drift," which is well-documented empirically.

Companies that report unexpectedly bad (good) earnings news generally produce unusually low (high) returns after the announcement.

Heuristic-driven biases: 2. Overconfidence

2. Overconfidence

People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.

The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations.

Overconfidence is particularly seductive when people have special information or experience - no matter how insignificant - that persuades them to think that they have an investment edge. In reality, however, most of the so called sophisticated and knowledgeable investors do not outperform the market consistently.

Another factor contributing to overconfidence is the illusion of control. People tend to believe that they have influence over future outcomes in an uncertain environment. such an illusion may be fostered by factors like active involvement and positive early outcomes. Active involvement in a task like online investing gives investors a sense of control. Positive early outcomes, although they may be purely fortuitous, create a illusion of control.

Is overconfidence not likely to get corrected in the wake of failures? It does not happen as much as it should. Why?

People perhaps remain overconfident, despite failures, because they remember their successes and forget their failures.

Harvard psychologist Langer describes this phenomenon as "head I win, tail it's chance". Referred to as self-attribution bias, it means that people tend to ascribe their success to their skill and their failure to bad luck. Another reason for persistent overconfidence and optimism is the human tendency to focus on future plans rather than on past experience.

Overconfidence manifests itself in excessive trading in financial markets. It also explains the dominance of active portfolio management, despite the disappointing performance of many actively managed funds.

Heuristic-driven biases: 1. Representativeness

1. Representativeness

Representativeness refers to the tendency to form judgements based on stereotypes.

For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school. While representativeness may be a good rule of thumb, it can also lead people astray.

For example: Investors may be too quick to detect patterns in data that are in fact random.

Investors may believe that a healthy growth of earnings in the past may be representative of high growth rate in future. They may not realise that there is a lot of randomness in earnings growth rates.

Investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance.

Investors may become overly optimistic about past winners and overly pessimistic about past losers.

Investors generally assume that good companies are good stocks, although the opposite holds true most of the time.

Tuesday, 2 September 2008

Behavioural Finance: Heuristic-Driven Biases

The important heuristic-driven biases and cogniive errors that impair judgement are:
  • Representativeness
  • Overconfidence
  • Anchoring
  • Aversion to ambiguity
  • Innumeracy

1. Representativeness

Representativeness refers to the tendency to form judgements based on stereotypes. For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school

2. Overconfidence

People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge.

3. Anchoring

After forming an opinon, people are often unwilling to change it, even though they receive new information that is relevant.

4. Aversion to Ambiguity

People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes. In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.

5. Innumeracy

People have difficulty with numbers.

Strategies for Overcoming Psychological Biases

The field of behavioural finance highlights many psychological biases can impair the quality of investment decision making. Here are some strategies for overcoming the psychological biases:

1. Understanding the Biases.

Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, "We have met the enemy - and it's us". So, understand your biases (the enemy within) as this is an important step in avoiding them.

2. Focus on the Big Picture.

Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyrations of the market.

3. Follow a Set of Quantitative Investment Criteria.

It is helpful to use a set of quantitative criteria such as
  • the price-earnings ratio being not more than 15,
  • the price to book ratio not more than 5,
  • the growth rate of earnings being at least 12%, and so on.
Quantitative criteria tend to mitigate the influence of emotion, hearsay, rumour and psychological biases.

4. Diversify

If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.

5. Control Your Investment Environment

If you are on a diet, you should not have tempting sweets and savouries on your dining table. Likewise, if you want to discipline your investment activity, you should regulate or control your investment environment. Here are some ways of doing so:
  • Check your stocks only once every month.
  • Trade only once every month and preferably on the same day of the month.
  • Review your portfolio once or twice a year.

6. Strive to Earn Market Returns

Seek to earn returns in line with what the market offers. If you strive to outperform the market, you are likely to succumb to psychological biases.

7. Review Your Biases Periodically

Once in a year, review your psychological biases. This will throw up pointers to contain such biases in the future.

Behavioural finance - The Irrational Influences

From the mid-1950s, the field of finance has been dominated by the traditional finance model (also referred to as the standard finance model) developed primarily by the economists of the University of Chicago. The central assumption of the traditional finance model is that people are rational.

However, psychologists challenged this assumption. They argued that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.

The finance field was reluctant to accept the view of psychologists who proposed the behavioural finance model. As the evidence of the influence of psychology and emotions on decisions became more convincing, behavioural finance has received greater acceptance.

Although there is diagreement about when, how, and why psychology influences investment decisions, the award of 2002 Nobel Prize in Economics to psychologist Daniel Kahneman and experimental economist Vernon Smith is seen by many as a vindication of the field of behavioural finance.

Key differences

The key differences between "traditional finance" and "behavioural finance" are as follows:

1. Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioural finance recognises that people employ imperfect rules of thumb (heuristics) to process data which induces biases in their beliefs and predisposes them to commit errors.

2. Traditional finance presupposes that people view all decisions throgh the transparent and objective lens of risk and return. Put differently, the form (or frame) used to describe a problem is inconsequential. In contrast, behavioural finance postulates that perceptions of risk and return are significantly influence by how decision problems are framed. In other words, behavioural finance assumes frame dependence.

3. Traditional finance assumes that people are guided by reason and logic and independent judgment. Behavioural finance, on the other hand, recognises that emotions and herd instincts play an important role in influencing decisions.

4. Traditional finance argues that markets are efficient, implying that the price of each security is an unbiased estimate of its intrinsic value. In contrast, behavioural finance contends that heuristic-driven biases and errors, frame dependence, and effects of emotions and social influence often lead to discrepancy between market price and fundamental value, thus market inefficiencies.

Types of Risk (Total risk = Unique risk + Market risk)

Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows:

Total risk = Unique risk + Market risk

Unique risk (Diversifiable risk or Unsystematic risk)

The unique risk of security represents that portion of its total risk which stems from firm-specific factors like
  • the development of a new product,
  • a labour strike, or
  • the emergence of a new competitor.
Events of this nature primarily affect the specific firm and not all firms in general.

Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.

Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.

Market risk (Non-diversifiable risk or Systematic risk)

The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like
  • the growth rate of GDP,
  • the level of government spending,
  • money supply,
  • interest rate structure, and
  • inflation rate.

Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.

Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.

Market Risk

Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate.

While there can be several reasons for this fluctuation, a major cause appears to be the changing psychology of the investors.

There are periods when the investors become bullish and their investment horizons lengthen. Investor optimism, which may border on euphoria, during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the shares.

On the other hand, when a wave of pessimism (which often is an exaggerated response to some unfavourable political or economic development) sweeps the market, investors turn bearish and myopic. Prices of almost all equity shares regiter decline as fear and uncertainty pervade the market.

The market tends to move in cycles. As John Train says:

"You need to get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later."

The cycles are caused by mass psychology. As John Train explains:

"The ebb and flow of mass emotion is quite regular: Panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts, and public feeling slides off again into concern, desperation, and finally a new panic."

One would expect large scale participation of institutions to dampen the price fluctuations in the market. After all institutional investors have core professional expertise to do fundamental analysis and greater financial resources to act on fundamental analysis. However, nothing of ths kind has happened.

On the contrary, price fluctuations seem to have become wider after the arrival of institutional investors in larger numbers.

Why? Perhaps the institutions and their analysts have not displayed more prudence and rationality than the general investing public and have succumbed in equal measure to the temptation to speculate.

As John Maynard Keynes had argued, factors that contribute to the volatility of the market are not likely to diminish when expert professionals supposedly possessing better judgment and knowledge compete in the market place.

Why? According to Keynes, even these peope are concerned with speculation (the activity of forecasting the psychology of the market) and not enterprise (the activity of forecasting the prospective yield of assets over their whole life).

Interest Rate Risk

The changes in interest rate have a bearing on the welfare of investors. As the interest rate goes up, the market price of existing fixed income securities falls, and vice versa.

This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security.

For example, a debenture that has a face value of MR 100 and a fixed rate of 12% will sell at a discount if the interest rate moves up from, say, 1% to 14%.

While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit somewhat indirectly.

The changes in the relative yields of debentures and equity shares influence equity prices.

Business risk

As a holder of corporate securities (equity shares or debentures), you are exposed to the risk of poor business performance.

This may be caused by a variety of factors like
  1. heightened competition,
  2. emergence of new technologies,
  3. development of substitute products,
  4. shifts in consumer preferences,
  5. inadequate supply of essential inputs,
  6. changes in government policies and so on.

Often, of course, the principal factor may be inept and incompetent management.

The poor business performance definitely affects the interest of equity shareholders, who have a residual claim on the income and wealth of the firm.

It can also affect the interest of debenture holders if the ability of the firm to meet its interest and principal payment obligation is impaired. In such a case, debenture holders face the prospect of default risk.


You cannot talk about investment returns without talking about risk because investment decisions invariably involve a trade-off between the two.

Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.

More specifically, most investors are concerned about the actual outcome being less than the expected outcome.

The wider the range of possible outcomes, the greater the risk.

Sources of Risk

Risk emanates from several sources. The three major ones are:

1. business risk,

2. interest rate risk, and

3. market risk.

Types of Risk

Modern Portfolio Theory looks at risk from a different perspective. It divides total risk as follows:

Total risk = Unique risk + Market risk


Return is the primary motivating force that drives nvestment. It represents the reward for undertaking investment. Since the game of investing is about returns (after allowing for risk), measurement of realised (historical) returns is necessary to assess how well the investment manager has done. In addition, historical returns are often used as an important input in estimating future (prospective) returns.

The Components of Return

The return of an investment consists of two components.

Current Return: The first component that often comes to mind when one is thinking about return is the periodic cash flow (income), such as dividend or interest, generated by the investment. Current return is measured as the periodic income in relation to the beginnin price of the investment.

Capital Return: The second component of return is reflected in the price change called the capital return - it is simply the price appreciation (or depreciation) divided by the beginning price of the asset. For assets like equity stocks, the capital return predominates.

Thus, the total return for any security (or for that matter any asset) is defined as:

Total Return = Current Return + Capital Return

The current return can be zero or positive, whereas the capital return can be negaive, zero, or positive.

Risk and Return - Two Sides of the Investment Coin

Investment decisions are influenced by various motives.

Some people invest in a business to acquire control and enjoy the prestige associated with it.

Some people invest in expensive yatchs and famous villas to display their wealth.

Most investors, however, are largely guided by the pecuniary motive of earning a return on their investment.

For earning returns investors have to almost invariably bear some risk.

In general, risk and return go hand in hand.

While investors like returns they abhor risk.

Investment decisions, therefore, involve a tradeoff between risk and return.

Since risk and return are central to investment decisions, we must understand what risk and return are and how they should be measured.

Monday, 1 September 2008

Estimation of Intrinsic Value

The procedure commonly employed by investment analysts to estimate the intrinsic vlaue of a share consists of the following steps:

1. Estimate the expected earnings per share

2. Establish a PE ratio

3. Develop a value anchor and a value range

Determine a Value Anchor and a Value Range

1. Determine a Value Anchor

The value anchor is obtained as follows:

= Projected EPS x Appropriate PE ratio

In our illustration, the projected EPS is 5.00 and the appropriate PE multiple is 6.87. Hence the valu anchor is 34.35. However, as valuation is inherently an uncertain and imprecise exercise, it would be naive to put great faith in a single point intrinsic value estimate. Practical wisdom calls for defining an intrinsic value range around the single point estimate.

2. Determine a Value Range

For example, in the above illustration, where an intrinsic value estimate of 34.35 has been arrived at, it may be more sensible to talk of an intrinsic value range of say 30 to 38. When you define a range like this, you are essentially saying that a "there may be a bias and error in my estimate. In view of this, feel that the value range is 30 to 38." Given this value range, your decision rule may be as follows:

Market Price*** (Decision)
< 30***********(Buy)
30 to 28********(Hold)

Estimating the Expected EPS & Cash Flow per Share

1. Estimating the Expected EPS

Based on how the company has done in the past, how it is faring currently, and how it is likely to do in future, the investment analyst estimates the future (expected ) EPS. An estimate of EPS is an educated guesses about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products and services of the company, talk to competitors and suppliers, and interview management to understand the evolving prospects of the company.

As an illustration, the expected EPS for Horizon Limited for the year 20x8 is developed:

20x7 (Actual)***20x8 (Projected)***Assumption
Net sales
840***924***Increase by 10%
Cost of goods sold
638***708***Increase by 11%
Gross profit
Operating expenses
74***81***Increase by 9.5%
S&GA expenses
Operating profit
Non-operating surplus/deficit
2***2***No change
Profit before interest and tax (PBIT)
25***24***Decrease by 4%
Profit before tax
35***38***Increase by 8.57%
Profit after tax
Number of equity shares
15 m *** 15 m

Note that the EPS forecast is based on a number of assumptions about the behaviour of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.

As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties, product prices, interest rates, asset turnover, and income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.

It is better to work with a range rather than a single number. Paint few scenarios - optimistic, pessimistic, and normal - and examine what is likely to happen to the company under these circumstances.

2. Estimating the Cash Flow per Share

In addition to the EPS, the cash flow per share which is defined as:

= (Profit After Tax + Depreciation and other non-cash charges)/Number of outstanding equity shares

is also estimated. The cash flow per share in the above illustration is (75+34)/15 = 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued, maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs, one can ignore the book depreciation charge. (This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate).

Establishing a PE Ratio

The PE ratio maybe derived from the
  1. constant growth dividend model, or
  2. cross-section analysis, or
  3. historical analysis.

Constant Growth Dividend Model.

We derive the PE ratio for a constant growth firm from the constant growth dividend discount model.

PE Ratio
= Dividend payout ratio/ (Required return on equity - Expected growth rate in dividends)

Dividend Payout Ratio: Most companies treat their dividend commitment seriously. Consequently, once dividends are set at a certain level, they are not reduced unless there is no alternative. Further, dividends are not increased unless it is clear that a higher level of dividends can be sustained. Thanks to these policies, dividends adjust with a lag to earnings.
If the dividend payout ratio increases the above ratio increases, which has a favourable effect ont he price-earnings multiple. However, an increasein the dividend payout ratio has the effect of lowering the expected growth rate of dividends int he denomination of the above ratio which leads to a decrease in the price-earnings multiple. On the whole, in most cases, these two effects are likely to balance out.

Required Return on Equity: The required return on equity is a function of the risk-free rate of return and a risk premium. According to the capital asset pricing model, a popularly used risk-return model, the rquired return on equity is:
= Risk-free return + (Beta of equity) ( Expected market risk premium)

Expected Growth Rate in Dividends: The third variable influencing the PE ratio is the expected growth rate in dividends. The expected growth rate in dividends is equal to:
= Retention ratio x Return on Equity.

Cross-Section Analysis

You can look at the PE ratios of similar firms in the industry and take a view on what is a reasonable PE ratio for the subject company.

Alternatively, you can conduct cross-section regression analysis wherein the PE ratio is regressed on several fundamental variables. Here is an illustrative specification:

PE ratio
= a1 + a2 Growth rate in earnings + a2 Dividend payout ratio + a3 Variability of earnings + a4 Company size.

Based on the estimated coefficients of such cross-section regression analysis, the PE ratio for the subject firm may be derived.

Historical Analysis.

You can look at the historical PE ratio of the subject company and take a view on what is a reasonable PE ratio, taking into account the changes in the capital market and the evolving competition.

As an illustration, the prospective PE ratio for Horizon Limited for the past three years was

PE Ratio 20x5 9.25, 20x6 6.63, 20x7 6.23
The average PE ratio for Horizon Limited was: (9.25+6.63+6.23)/3 = 7.37
Considering the changing conditions in the capital market and the emerging competition for Horizon Limite you may say that the average PE for the past three years is applicable in the immediate future as well.

The Weighted PE Ratio

We arrived at two PE ratio estimates:
PE ratio based on the constant growth dividend discount model: 6.36
PE ratio based on historical analysis: 7.37
We can combine these two estimates by taking a simple arithmetic average of them - this means that both the estimates are accorded equal weight. Doing so, we get the weighted PE ratio of:
(6.36+7.37)/2 = 6.87

Different PE ratios

Estimated EPS is based on a number of assumptions about the behaviour of revenues and costs. The reliability of the EPS forecast hinges critically on how realistic are these assumptions.

The other half of the valuation exercise is concerned with the price-earnings ratio which reflects the price investors are willing to pay per cents of EPS. In essence, it represens the market's summary evaluation of a company's prospects

Note that different PE ratios can be calculated for the same stock at any given point in time:

PE ratio based on last year's reported earnings
PE ratio based on trailing 12 months earnings
PE ratio based on current year's expected earnings
PE ratio based on the following year's expected earnings

An example may be given to illustrate the different PE ratios. The equity stock of ABC Limited is trading on August 1, 20x5 for MR 120 and the following EPS data is available:

EPS for last year (April 1, 20x4 - March 31, 20x5): 8 sen
EPS for trailing 12 months (July1, 20x4 - June 30, 20x5): 8.5 sen
EPS expected for the current year (April 1, 20x5 - March 31, 20x6): 9 sen
EPS expected for the following year (April 1, 20x6 -March 31, 20x7): 10 sen

The different PE ratios are as follows:

PE ratio based o last year's reported earnings: 120/8 = 15.0
PE ratio based on trailing 12 months earnings: 120/8.5 = 14.1
PE ratio based on current year's expected earnings: 120/9.0 = 13.3
PE ratio based on the folowing year's expected earnings: 120/10.0 = 12.0

We will generally use the PE ratio based on current year's expected earnings.

Peter Lynch's Classification of Companies

There are different ways of classifying shares. Here is Peter Lynch's classification of companies (and by derivation, shares).

Slow growers: Large and ageing companies that are expected to grow slightly faster than the gross national product.

Stalwarts: Giant companies that are faster than slow growers but are not agile climbers.

Fast growers: Small, aggressive new enterprises that grow at 10 to 25% a year.

Cyclicals: Companies whose sales and profit rise and fall in a regular, though not completely predicatable fashion.

Turnarounds: Companies which are steeped in accumuated losses but which show signs of recovery. Turnaround companies have the potential to make up lose ground quickly.

Stock Market Classification of Equity Shares

Stock market classification of Equity Shares

Blue chip shares: Shares of large, well-established, and financially strong companies with an impressive record of earnings and dividends.

Growth shares: Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability.

Income shares: Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios.

Cyclical shares: Shares of companies that have a pronounced cyclicality in their operations.

Defensive shares: Shares of companies that are relatively unaffected by the ups and downs in general business conditions.

Speculative shares: Shares that tend to fluctute wdely because there is a lot of speculative trading in them.

Note that the above classification is only indicative. It should not be regarded as rigid and straightjacketed. Often you can't pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories.

The smart way to get rich

The smart way to get rich
To get big rewards, you'll need to take some risks. What's important is knowing -- based on your needs, your time frame and other factors -- just how much danger you can handle.

By Annie Logue, MSN Money
Feel like taking a risk in hopes of hitting the jackpot on a rocket stock?
Before you make the leap, you might want to get a grip on risk.

Risk is great . . . when you make money
Prices go up, prices go down, and you never know which way they're headed next. A lot of folks would say, well, that's risk. But really that's only half the picture. The other half is what you do in response.

"Nothing goes up forever"
After all, there's nothing wrong with risk itself. What's important is how you handle it. To know how to manage the risk-reward equation, you're first going to have to get a grip on what you're playing with -- and how much you can afford to lose.

Graphic: How risky is it?
It's pretty hard to talk about investment risk without falling into a lot of clichés about roller coasters and bungee jumping and being able to sleep at night. That imagery is entertaining but maybe not terribly helpful. Instead, let's start with the basics. We don't want to lose money, right?
"Obviously, negative return is risk," says Lee Schultheis, the CEO and chief investment strategist at AIP Mutual Funds in White Plains, N.Y.
Pros such as Schultheis use some pretty powerful computer-driven tools in their analysis of risk. Here are just a few of the concepts that are important to them:
Standard deviation, much beloved of finance professors, measures how much the results of a process tend to vary. The higher the standard deviation, the more unpredictable the results.
Correlation, used by those managing diversified portfolios, tells you how much two assets move together to reinforce -- or offset -- performance.
Value at risk, often used by hedge funds, measures the likelihood that you will lose all of your money in any time period.
All three are mathematical concepts and require some comfort with statistics to calculate -- but not to understand. Each translates the uncertainties of risk into mathematical estimates of likelihood that offer a good basis for planning.

Math won't help everything
If you have an investment with a high standard deviation, close correlation to other investments or a high value at risk, you're taking on significantly more risk. If more than one of those factors is involved, watch out.
Let's say you're thinking about doubling up an investment in technology stocks. Results in that sector are going to be erratic to begin with. But because the new investment correlates positively with stuff you already own, the risk to you is much greater.
Normally, riskier investments hold the promise of greater returns over the long run. But that may not help you sleep at night.

What are acceptable losses?
Professionals will use concepts like standard deviation and correlation to balance risks in ways that can get pretty complicated. The average investor isn't equipped for that sort of thing. Fortunately, there are approaches that are a lot simpler to manage while still offering an approach that is fundamentally sound.
Edward Gjertsen, a certified financial planner with Mack Investment Securities in Glenview, Ill., encourages his clients to think about risk in a more personal way. He tries to focus their attention on their own fundamental needs.

How safe is your job?
He offers clients what he calls his seven-day cash challenge. Clients are asked to withdraw as much cash as they think they will need for all of their expenses -- coffee, groceries, whatever -- during one week. Then he asks them to report back on when the money runs out.
Very few folks make it through all seven days without a trip to the ATM.
"The ones who do it find it's eye-opening," Gjertsen says.
That's because most of us have a lot of expenses that we don't think about: birthday presents, a manicure before a party, prescription refills and the like.
"Every time somebody swipes a card, somebody's making money somewhere," Gjertsen says. "You don't necessarily realize this money is whipping through your hands."
The cash challenge helps Gjertsen's clients understand where they should draw the line on risk. Most of us do not want to gamble away the money we need to pay basic expenses and buy an occasional birthday present. But if we can take care of our basic needs, plan for college for the kids and fund a reasonable retirement, say, and still have a bit of money left over, that's different. There, maybe a bit of additional risk makes sense.
"Your portfolio should reflect whatever your underlying risk preferences are," says Leo Harmon, a senior director at Fiduciary Management Associates in Chicago.
To handle risk intelligently, you first need to make sure you can afford it. Then make sure it fits well into our overall investment strategy. Diversify. Don't bet the farm on a single sector. And recognize that it's not just how much money you'll need, it's when you'll need it.
For instance: A technology sector that sees a lot of ups and downs may be the worst possible investment for an individual who is planning to retire next year. But for the person with a 10- or 20-year time horizon, the same sector might make a lot of sense.
In the right situation, the addition of some well-managed risk makes sense and should have a positive effect on a portfolio. To profit from additional risk, though, you have to be comfortable enough to ride out the short-term fluctuations. Be prepared for some volatility, and understand that the ups and downs tend to get more extreme as the risks go up.

How competing economies help you
Meanwhile: Bear in mind that all investments carry risks of one sort or another. Just because a security has low volatility doesn't mean that there's no potential for loss. A steady loser is a lot worse than an investment that goes down a lot but then goes up by even more.
"It might not feel bad along the way because it only goes down a little bit at a time," AIP Mutual Funds' Schultheis says of the steady losers. In the end, though, a loss is still a loss.
If you think it through, risk can work in your favor. And you can still sleep at night.

Published April 11, 2008

Investing: When to bet the farm

Investing: When to bet the farm

Big payoffs often require big risks. Bet wrong, and you could lose everything. Do you have what it takes? And how do you assess whether a dicey investment is worth it?

By Annie Logue, MSN Money
You want a big return? How big a risk do you want to take to get it? Gauging the risks associated with really promising investments, and handling those risks appropriately, can change your life.
"It's never safe to take a risk, by definition," says Carl Luft, an associate professor of finance at DePaul University in Chicago.
Yet successful investors take major risks all the time. They succeed because they do their research, can afford to lose the money they invest in high-risk schemes and are able to make up any losses they incur with other investments, which frequently involve complementary or counterbalancing risks.Whether considering an investment in a stock, a privately held startup or a hedge fund -- all high-risk propositions -- investors should start by digging through the details of the business case to figure out how the return on investment is likely to be generated. How big a payoff might the investment produce? And how likely is success?
Successful investors look hard at the downside as well. What would the price of failure be? And how likely is that?

Just jump in and take a risk
And what about all the outcomes in between?
Luft emphasizes that successful investors tend to have a broad view, taking the downside into account with the upside. They plan on an outcome somewhere in the middle of the range of possibilities. That is their "expected return."
"An expected return is an average," Luft says. "It's the probability of all of the outcomes."
Risk assessment gets pretty sophisticated at risk-oriented hedge funds. These funds combine and counterbalance risks to put together exotic investment strategies that increase an investor's upside while controlling the downside -- all for a price. But the basics are just common sense.
Russell Lundeberg, the chief investment officer for Barrett Capital Management in Richmond, Va., spends his days researching investments both risky and safe for the wealthy families in the firm's client base. He researches basic business practices as well as the big-picture business opportunity.
"The No. 1 most overlooked aspect of hedge fund due diligence is on the operational side," he says. "The things that can be potential risks and pitfalls are not always easy to spot."
Among the not-so-obvious business risks, Lundberg mentions high employee turnover, sloppy accounting and computers that aren't backed up. A mistake in the office can wipe out an investment's potential return even in the most promising environment, Lundeberg says.
Our own personalities add complexity to high-risk situations.
Bill Gurtin of Gurtin Fixed Income Management in San Diego points out the risks associated with overly emotional reactions.
"What you don't want to happen is for people to get emotional with the market," he says.
The more emotional we get, the more likely it is we will make a mistake, Gurtin explains.
A company's business prospects can be measured and evaluated statistically, but there is no easy measure for mood swings. Before making any moves, people contemplating high-risk investments should come to grips with their emotional makeup and know how they are likely to react.

Graphic: Three ways to analyze a company (Quantitative, Qualitative and Technical Analysis)
Where risk is high, the investor needs to analyze his or her life situation.

Is financial risk really risky?
"There are times in your life when it's appropriate to take different levels of risk," Gurtin says.
Age is a big factor. Age changes us in a lot of ways. We gain emotional maturity. At the same time, the nature of our financial obligations changes, and the time horizon for risk gets tighter.
"Let's say you're young, in your mid-20s," Luft says. "If you take a big risk and something goes wrong, you have time to recover." On the other hand, the middle-aged homeowner probably needs a bigger safety net, especially if there are kids who need braces or there are college costs to consider.
Even a high-risk investment can be a very positive part of a portfolio when it's appropriate to a person's situation and is well-managed.
"In investing and in life, you have to look at everything on a risk-and-reward basis,"
says Manny Weintraub, the president of Integre Advisors, a New York firm that manages equities for long-term growth. "Volatility is not the end of the world."

Risk lesson from the OTB
Weintraub is a good example. He left the investment firm of Neuberger Berman in 2003 to start his own firm. He knew most new businesses fail, but he had a lot of confidence in his own investment skills. If the business went under, he reasoned, he could always get a job with another firm.
"Careers are actually the easiest place to take risks, as long as you don't burn your bridges," Weintraub says.
Luft suggests younger investors, particularly, should be ready to gamble with their careers.
But in the same breath he cautions as professional investors often do: Risk only as much as you can afford to lose, he says.

Published Aug. 28, 2008