Risk and Ruin

Risk and Ruin 

You can be risk loving and yet completely averse to ruin.  And indeed, you should.

The idea is that you have to take risk to get ahead, but no risk that can wipe you out is ever worth taking.

Russian roulette

The odds are in your favour when playing Russian roulette.  But the downside is not worth the potential upside.   There is no margin of safety that can compensate for the risk.

Playing Russian roulette with your own money

Same with money.  The odds of many lucrative things are in your favour.   But if something has 95% odds of being right, the 5% odds of being wrong means you will almost certainly experience the downside at some point in your life.  And if the cost of the downside is ruin, the upside the other 95% of the time likely isn't worth the risk, no matter how appealing it looks.

Leverage is capable of producing ruin

Leverage is the devil here. Leverage - taking on debt to make your money go further - pushes routine risks into something capable of producing ruin.  The danger is that rational optimism most of the time masks the odds of ruin some of the time.   The result is we systematically underestimate risk.   

Housing prices fell 30% last decade.  A few companies defaulted on their debt.  That is capitalism.  It happens.  But those with high leverage has a double wipeout:  Not only were they left broke, but being wiped out erased every opportunity to get back in the game at the very moment opportunity was ripe.  A home owner wiped out in 2009 had no chance of taking advantage of cheap mortgage rates in 2010.  Lehman Brothers had no chance of investing in cheap debt in 2009.  They were done.

Survive to succeed

I take risk with one portion of my own money and am terrified with the other.  This is not inconsistent, but the psychology of money would lead you to believe that it is.  I just want to ensure I can remain standing long enough for my risks to pay off.   You have to survive to succeed.   The ability to do what you want, when you want, for as long as you want, has an infinite ROI.

You have to give yourself room for error.  You have to plan on your plan not going according to plan.

The best way to achieve felicity is to aim low.  (Charlie Munger)

Three elements of a value-investment strategy: Bottom-up approach, Absolute performance orientation, and Managing risk.

The primary goal of value investors is to avoid losing money. 

Three elements of a value-investment strategy make achievement of that goal possible.

1.   A bottom-up approach, searching for low-risk bargains one at a time through fundamental analysis, is the surest way I know to avoid losing money.

2.  An absolute performance orientation is consistent with loss avoidance; a relative-performance orientation is not.

3.  Finally, paying careful attention to risk - the probability and amount of loss due to permanent value impairments - will help investors avoid losing money.



So long as generating portfolio cash inflow is not inconsistent with earning acceptable returns, investors can reduce the opportunity cost resulting from interim price declines even as they achieve their long-term investment goals.

Risk and Return: Risk does not create incremental return, only Price can

While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return.




Most investors seem confused about risk.

Some insist that risk and return are ALWAYS positively correlated, the greater the risk, the greater the return.  This is in fact, a basic tenet of the capital-asset-pricing model taught in nearly all business schools, yet it is not always true.

Others mistakenly equate risk with volatility, emphasizing the "risk" of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments.

A positive correlation between risk and return would hold consistently only in an efficient market.

• Any disparities would be immediately corrected; this is what would make the market efficient.  

In inefficient markets it is possible to find investments offering high returns with low risk.  These arise

• when information is not widely available, 
• when an investment is particularly complicated to analyze, or 
• when investors buy and sell for reasons unrelated to value.  

It is also common place to discover high risk investments offering low returns.  

• Overpriced and therefore risky investments are often available because the financial markets are biased toward overvaluation and because it is difficult for market forces to correct an overvalued condition if enough speculators persist in overpaying.  
• Also, unscrupulous operators will always make overpriced investments available to anyone willing to buy; they are not legally required to sell at a fair price.

Risk and return must be assessed independently for every investment.

Since the financial markets are inefficient a good deal of the time, investors cannot simply select a level of risk and be confident that it will be reflected in the accompanying returns.  

Risk and return must instead be assessed independently for every investment.

In point of fact, greater risk does not guarantee greater return.

• To the contrary, risk erodes return by causing losses.  
• It is only when investor shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred.  

By itself risk does not create incremental return, only price can accomplish that.  

RISK DISCLOSURE

RISK DISCLOSURE

Risk relates to future events that are quantifiable.

Uncertainties are future events that are indeterminate and non-quantifiable.  

In the 1990s, companies began to move from simple risk analysis to more proactive risk management.

Companies should disclose their risk management practices.

IFRS 7 deals with the risks associated with financial instruments.

There should also be discussion of the major risks and uncertainties facing the company and how these are being dealt with.  

The main classes of risk are identified as:

• -          Market risk:  exchange rate, interest rate or other price movements;
• -          Liquidity risk:  possible problems in making cash available.
• -          Credit risk:  customers fail to pay.

If there is an existing or potential liability, this is fully disclosed in the annual report as you need to know about this in order to properly assess the company.

RISK FACTORS

The risk factors are normally listed in order of significance.  

These provide some insight into management’s view of the risks seen to be facing the business.  

These may be related to a country’s economy, or a company’s industry or geographic location.  

Market risk includes interest rates, foreign exchange and commodity price risk.

“New” measure of risk.

An alternative approach to company risk assessment has been offered,  It is suggested that the number of times the word “new” appears in the annual report may provide a measure of risk.

Volatility, Risk and You as an Investor. "Take no risk" is not an option.

As an investor, you have to know something about volatility and risk, where it comes from and how it can affect your investment performance.

If you avoid volatility altogether, example, keeping your money in fixed deposits or risk free saving deposits, you will eventually be sorry in all but the most remote black swan scenarios.



What are you to do?  

You will have to face the risk and decide how you want to go forward in your investing.  There are at least four things you can do about risk, to manage it.

1.  Avoid risk:  accept risk-free returns of 2% or less.
2.  Retain risk:  know it's there, know its dangers, and deal with them.
3.  Reduce risk:  be smart about what you are doing by taking the necessary precautious
4.  Transfer risk:  make contrarian investments or buy derivatives -another scary concept, to insure your portfolio.



The best investing approach to risk taking

The best investing approach overall is some combination of the four.

Warren Buffett's strategy was primarily to reduce risk by knowing what he was doing.  We can embrace a lot of what he has to say, though we cannot all be so masterful.

We may want to avoid risk with certain portions of our investments, like an emergency or college fund as we approach our children's college years.

We will retain risks, knowing it is hard to quantify or measure just how much risk we want to retain.

We will reduce risks by being smart, which means knowing where the risks come from and taking steps, like doing smart, forward-looking research to reduce them.

There are ways to transfer some of the risks by buying and selling certain types of options to trade a relatively more volatile future for certain cash today or to insure a portfolio outright.




"Take no risk" is not an option.

If you have money, you will take risk.

If you want your money to work for you some day, you have to take a little more risk, especially in view of long-term inflation.

If you embrace and manage the risk properly and stay within yourself, you won't lose sleep at night.  

What is risky is what makes you lose sleep at night.

This is anything that's psychologically upsetting or distracting that causes you not to be wholly focused or effective on the rest of what's gong on around you.




Risk checklist

Here is a short risk checklist:

• If you cannot sleep at night, you are taking too much risk.
• If you cannot function normally without being distracted; if you are irritable or angry or pensive or withdrawn, you are probably taking too much risk.
• If you are risking something greater than you can afford to lose, you are taking too much risk.
• If you are truly worried about your long-term financial security, you are taking too much risk.
• The converse is true too.  If you are truly worried about long term financial security, you may not be taking enough risk; you are sacrificing too much return.

Conclusion

In the end, it all depends on how much risk you want to take and how you feel about risk to achieve a balance you are comfortable with.

Low volatility investing is the acceptance and management of some investing risk to produce better-than-market returns while minimizing exposure to the wealth-destroying sharp downturns that can have long-term effects on investing performance.

A Horrifying Storm Is Brewing Inside the Stock Market

A Horrifying Storm Is Brewing Inside the Stock Market

The markets continue to hover around record highs. But there could be a storm brewing investors need to watch.

MoneyShow.com
Aug 8, 2018


Don't forget risk.

Leverage remains insanely high at $647 billion, 55% higher than at the 2007 double housing and stock bubble peak and 116% higher than the 2000 tech mania peak. Total margin debt has exceeded 3% of Gross Domestic Product only three times; in 1929 as the madness of the Roaring Twenties peaked, last year and this year.

Leverage may seem like magic on the way up but the effects are horrifying when prices fall. The unwinding of margin debt between 1929-1932 resulted in a economic depression as the phenomenal wealth driving the nation's economy evaporated.

Stock prices fell as much as 90% after soaring 4.2-fold in only nine years and four months. The damage was so extensive that the Dow Industrials did not fully recover until 26 years later in 1955.

Thus, we look at today's stock market and worry about the similarities. In only nine years and four months from the previous bear market bottom in March 2009, the Dow Jones Industrial Average has now surged 4.1-fold, almost exactly the same as the run into the 1929 peak.

While we do not expect an exact repeat of the 1929-32 period when excessive leverage led to a crash and a collapse into an economic depression, the current environment is way too similar to past manias and in certain aspects — primarily leverage — is far worse than the prior two peaks in March 2000 and October 2007. Given our long term target of Dow 14,719, down 43% from today, we have zero comfort for the long side.

Meanwhile, total dollar trading volume (DTV) now stands at yet another new record high. Over the last 12 months, total DTV is now $81.24 trillion, up nearly 15% from last years record, roughly 75% higher than at the 2007 double bubble peak and 150% higher than at the tech mania peak.

The trend to trade more has kept average holding periods for U.S. stocks to just over four months. When stocks are held for the long term, valuation becomes a primary consideration. The shorter period one holds stocks, the less likely one is to rely on valuations, hence valuation methodologies are now routinely shunned and scorned in favor of chasing momentum.

Sentiment is perhaps the most significant driver of price, but it is not mere excessive optimism that makes the current environment so dangerous. Excessive valuations have been in place for so long that they are now accepted as entirely normal.

In the same way that buying stocks for 10% down in 1929 was regarded as normal, in the same way the "Nifty Fifty" one decision stocks in 1972 were considered normal, in the same way Nasdaq at a 250 P/E multiple in 2000 was considered normal, today's environment is accepted as normal and forecasts of higher prices abound.

In a CNBC survey of 19 top Wall Street firms, every strategist forecast higher prices and an average gain of another 10.6% through the remainder of the year. We are far more comfortable on the other side of the fence. Risks on the long side continue to be insanely high.

History has shown 30% downturns occur on average, roughly once every nine years. We are astonished how little attention is paid to risk parameters, even at this point when it is so ridiculously obvious how much leverage is built into stock prices and how overvalued stocks are.

We expect as bear market and our target remains Dow 14,719. Be careful. A storm is brewing.

By: Alan Newman, editor of CrossCurrents. Via MoneyShow.



https://finance.yahoo.com/m/79fb3e52-7b6f-3489-a678-e0731fb8b644/a-horrifying-storm-is-brewing.html

Good Proxies of Risk

Risk is embedded in how much you know about the business and how confidently you can predict the future outcome.

Circle of Competence:  The more certain you are about the business outcome, the less risky it is.

Time Horizon:  Shorter the time-horizon, higher the risk.  Benjamin Graham:  "In the short term, markets are a voting machine but in the long-term, it is a weighing machine."

Quality of Business:  The higher the likelihood that business can keep earning above average returns, the better the business.

Quality of Management:  Is Management looking after minority interest.


[Standard Deviation and Beta are NOT good proxies of risks.]

Central elements to a Value Investing Philosophy

The three central elements to a value investing philosophy:

1) A "bottom-up" strategy

2) Absolute (as opposed to relative) performance

3) A risk averse approach

Bottom-Up Investing

Most institutional investors use a top-down approach to investing. 

• That is, they try to forecast macroeconomic conditions, and then select investments based on that forecast. 
• This method of investing is far too prone to error, and doesn't allow for a margin of safety.
• For example, a top-down investor must be correct about the big picture, draw the correct conclusions from that big picture prediction, correctly apply those conclusions to attractive areas of investment, correctly specify specific securities, and finally, beat other investors to the punch who have made the same predictions.
• In addition to these challenges, top-down investors are buying based on concepts, themes and trends. 
• As such, there is no value element to their purchase decisions, and therefore they cannot buy with a margin of safety. 

On the other hand, bottom-up investors can apply a margin of safety and face a limited number of questions, e.g. what is the business worth, what is the downside etc.

Absolute Performance

Institutional investors are judged based on their performance relative to their peers or the market. 

• This results in a short-term investing horizon.
• Thus, if an investment opportunity appears undervalued but the value may not be recovered in the near-term, such investors may shun such an opportunity. 

Absolute investors don't judge themselves based on their performance to the market, which results in a short-term investing horizon. 

• Instead, they focus on investments that are undervalued, and are willing to wait for that value to come uncovered.

Risk

In the financial industry, returns are expected to correlate with risk. 

• That is, you cannot generate higher returns without taking more risk. 
• Downside risk and upside potential are considered to have the same probability (an implication of using beta, a measure of a stock's volatility versus the market).

Value investors think of risk very differently. 

• Downside risk and upside potential are not necessarily the same.
• Value investors seek to exploit this key difference by buying stocks with strong upsides and limited downsides.

Read:

Seth Klarman - Margin of Safety

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

The Philosophy of Value Investing and Why It Works

What is Value Investing?

The terms used to describe value investing don't require any accounting or finance background.

Value investing is described as paying 50 cents for a business worth $1. 

Warren Buffett's analogy using the maximum allowable weight of a bridge is used to illustrate how this margin of safety works:

"When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."

Margin of Safety (buying at a discount) is of utmost importance

What allows value investors to apply a margin of safety while most speculators and investors do not?

Again using a Buffett analogy to illustrate this:

A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.

Value investors do not buy businesses they do not understand, nor ones that they find risky. For example, they will avoid technology companies and commercial banks. 

Value investors will also invest where their securities are backed by tangible assets, to protect them from downside risk.

Because the future is unknown (e.g. a business worth $1 today might be worth 75 cents or $1.25 tomorrow), there is little to be gained by paying $1 for this business.

The margin of safety (buying at a discount) is therefore of utmost importance. 

Value investors gain an advantage when many:

• do not buy with a margin of safety, 
• remain fully invested at all times, and 
• trade stocks like pieces of paper with little regard to the underlying asset values.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Philosophy of value investing. Need to have clear strategies too.

Buffett's first two rules of value investing:

1) Don't Lose Money

2) Never Forget Rule #1

While it is easy to say these rules, by themselves they don't help investors. 

The future is uncertain. 

These are always unknown:

• future GDP growth rates, 
• inflation rates, and 
• other relevant factors to stock price returns. 

Furthermore, stocks are junior securities to debt and other firm obligations, making their future values even more uncertain. 

Stocks are certainly not risk free.

The investors need to have clear strategies, which they can follow, that will help them follow the above rules of Buffett's.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

The biggest risk of all.

Volatility is often equated to risk and many investors are concerned over this uncertain value of investments in the short term.

There are other kinds of risk too.


1.  Capital risk.
2.  Liquidity risk
3.  Currency risk
4.  Interest rate risk
5.  Financial risk
6.  Credit risk
7.  Event risk (Black Swan)

However, the biggest risk of all is when you elect not to invest or participate in the market.

You are assuring yourself of a declining standard of living because inflation will eat away the value of your holdings over time.

It is impossible to avoid risk in investing or in life.

Risk can be managed, through asset allocation and diversification, within and among asset classes and managing risk is crucial to investment success.

Decline in Market Price of holdings is not true risk or loss.

It is our conviction that the bona fide investor does not lose money merely because the market price of his holdings declines.  

Hence, the fact the decline may occur does not mean that he is running a true risk or loss.

If a group of well-selected common stock investment shows a satisfactory overall return as measured through a fair number of years then this group of investment has proved to be safe.

During that period, its market value was bound to fluctuate and likely than not, would sell for a while under the buyer's cost.

If that fall makes the investment risky, it would then have to be called both risky and safe at the same time.

This confusion may be avoided if we apply the concept of risk solely to a loss in value which:

• either is realized through an actual sale 
• or is caused by significant deterioration in the company's position 
• or more frequently, perhaps is the result of paying an excessive price in relation to the intrinsic worth of the security.

Many common stocks involve risks of such deterioration but it is our thesis that a properly executed group of investment in common stocks does not carry any substantial risk of this sort.


Ref:   Intelligent Investor by Benjamin Graham



Additional notes:

It is conventional to speak of good bonds as less risky than good preferred and that the latter as less risky than good common stocks.

From this was derived the popular prejudice against common stocks because they are not safe but we believe that what is here involved is not a true risk in the useful sense of the term.

If an investor's list has been competently selected in the first instance, there should be no need for frequent or numerous changes to the portfolio.

"No risk, no reward." "Higher risk, higher returns."

Risk:  The probability and value of financial loss.

Specific risk:  Risk that is associated with an individual investment.

Old cliche in finance:  "no risk, no reward".

But there is absolutely no reason to think that accepting risk inherently generates financial returns.  

The reality is the opposite:  all other things being equal, higher risk causes you lower financial gain, since the costs you incur as a result of the elevated risk corrode the value of your assets.

All other things being equal between two distinct investment options, if one option has greater risk, then the organisation selling that investment must offer a higher rate of return in order to attract investors.

It is not that the higher risk causes higher returns - it is that investors demand higher returns in order to accept the higher risk.


Various models are used to understand the relationship between risk and returns:

1. CAPM
2. APT
3. Value at Risk
4. Expected Shortfall
5. Ratings by underwriting agencies

Concept of "Risk." Market price fluctuation is NOT risk.

It is conventional to speak of good bonds as less risky than good preferred stocks and of the latter as less risky than good common stocks.

From this is derived the popular prejudice against common stocks because they are not "safe."

The words "risk" and "safety" are applied to securities in two different senses, with a resultant confusion in thought.

A bond is clearly proved unsafe when it defaults its interest or principal payments.

Similarly, if a preferred stock or even a common stock is bought with the expectation that a given rate of dividend will be continued, then a reduction or passing of the dividend means that it is unsafe.

It is also true that an investment contains a risk if there is a fair possibility that the holder may have to sell at a time when the price is well below cost.


Nevertheless, the idea of risk is often extended to apply to a possible decline in the price of a security, even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell at such times.

These chances are present in all securities, other than United States Savings Bonds, and to a greater extent in the general run of common stocks than in senior issues generally.

But we believe that what is here involved is not a true risk in the useful sense of the term.

$$$$

The man who holds a mortgage on a building might have to take a loss if he were forced to sell it at an unfavourable time.  That element is not taken into account in judging the safety or risk of ordinary real-estate mortgages, the only criterion being the certainty of punctual payments.

In the same way the risk attached to an ordinary commercial business is measured by the chance of its losing money, not by what would happen if the owner, were forced to sell.

We would emphasize our conviction that the bona fide investor does not lose money merely because the market price of his holdings declines; the fact that a decline may occur does not mean that he is running a true risk of loss.

$$$$$


If a group of well-selected common-stock investments shows a satisfactory over-all return, as measured through a fair number of years, then this group investment has proved to be "safe".

During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under the buyer's cost.  

If that fact makes the investment "risky" it would then have to be called both risky and safe at the same time.


$$$$$


This confusion may be avoided if we apply the concept of risk solely to a loss of value which either:
(a) is realized through actual sale or 
(b)  is ascertained to be caused by a significant deterioration in the company's position.

Many common stocks do involve risks of such deterioration.

But it is our thesis that a properly executed group investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed "risk" merely because of the element of price fluctuation.


Benjamin Graham
The Intelligent Investor

Risk and Time

Click here for an enlarged version: http://www.norstad.org/finance/risk-and-time.gif

A Better Bar Chart Showing Risk Over Time

This chart shows the growth of a $1000 investment in a random walk model of the S&P 500 stock market index over time horizons ranging from 1 to 40 years. It pretty much speaks for itself, I hope - that was the intention, anyway.

The chart clearly shows the dramatic increasing uncertainty of an S&P 500 stock investment as time horizon increases. 
-  For example, at 40 years, the chart gives only a 2 in 3 chance that the ending value will be somewhere between $14,000 and $166,000.
-  This is an enormous range of possible outcomes, and there's a significant 1 in 3 chance that the actual ending value will be below or above the range! You can't get much more uncertain than this.

As long as we're talking about risk, let's consider a really bad case. If instead of investing our $1000 in the S&P 500, we put it in a bank earning 6% interest, after 40 years we'd have $10,286.
-  This is 1.26 standard deviations below the median ending value of the S&P 500 investment.
-  The probability of ending up below this point is 10%. In other words, even over a very long 40 year time horizon, we still have about a 1 in 10 chance of ending up with less money than if we had put it in the bank!

Look at the median curve - the top of the purple rectangles, and follow it with your eye as time increases. You see the typical geometric growth you get with the magic of compounding.
-  Imagine the chart if all we drew was that curve, so we were illustrating only the median growth curve without showing the other possible outcomes and their ranges.
-  It would paint quite a different picture, wouldn't it? When you're doing financial planning, it's extremely important to look at both return and risk.

There's one problem with this chart. It involves a phenomenon called "reversion to mean." Some (but not all) academics and other experts believe that over long periods of time financial markets which have done better than usual in the past tend to do worse than usual in the future, and vice-versa. The effect of this phenomenon on the pure random walk model we've used to draw the chart is to decrease somewhat the standard deviations at longer time horizons. The net result is that the dramatic widening of the spread of possible outcomes shown in the chart is not as pronounced. -  The +1 standard deviation ending values (the tops of the bars) come down quite a bit, and the -1 standard deviation ending values come up a little bit. 

-  The phenomenon is not, however, anywhere near so pronounced as to actually make the +1 and -1 standard deviation curves get closer together over time. 

-  The basic conclusion that the uncertainty of the ending values increases with time does not change.

http://www.norstad.org/finance/risk-and-time.html

When evaluating the price, look at the potential return and the risk you must take to get that return.

When it comes to evaluating the price of a stock, you're really interested in just 2 things:

1.  The potential return, and
2.  The risk you must take to get that return.

If the potential return is worth the risk, the price is right.

If it is not, you can simply wait until it is.

As volatile as the stock market is, most stocks will sell at a favourable price sometime during the year.

To estimate the potential return, you will have to come up with a reasonable forecast of how high the price might go.  Knowing the hypothetical potential high price, you can estimate the potential return.

To evaluate risk, you will need to conservatively estimate the stock's potential lowest price.  If your potential gain is at least three times as much as you risk losing, your stock is probably selling at a fair price.



For example:

Stock TUW

Potential high price = $20
Potential low price = $10
Market price = $12

Potential gain = $20 - $12 = $18
Potential loss = $ $12 - $10 = $2
Therefore, potential gain : potential loss = $8 : $2 = 4 : 1

As the potential gain is at least 3x as much as you risk losing, the stock is probably selling at a fair price.

Understanding Risk and Return tradeoff

The higher the risk, the higher the potential return, and the LESS LIKELY it will achieve the higher return

UNDERSTANDING RISK

The rule of thumb is "the higher the risk, the higher the potential return," but you need to consider an addition to the rule so that it states the relationship more clearly:  the higher the risk, the higher the potential return, and the less likely it will achieve the higher return.

Buying a stock that is risky doesn't mean you will lose money and it doesn't mean it will achieve a 25% gain in one year.  However, both outcomes are possible.

How do you know what the risk is and how do you determine what the potential reward (stock price gain) should be?

7 investment risks and how to deal with them

The fact is that you cannot get rich without taking risks. Risks and rewards go hand in hand; and, typically, higher the risk you take, higher the returns you can expect. In fact, the first major Zurich Axiom on risk says: "Worry is not a sickness but a sign of health. If you are not worried, you are not risking enough". Then the minor axiom says: "Always play for meaningful stakes".

The secret, in other words, is to take calculated risks, not reckless risks.

In financial terms, among other things, it implies the possibility of receiving lower than expected return, or not receiving any return at all, or even not getting your principal amount back.

Every investment opportunity carries some risks or the other. In some investments, a certain type of risk may be predominant, and others not so significant. A full understanding of the various important risks is essential for taking calculated risks and making sensible investment decisions.

Seven major risks are present in varying degrees in different types of investments.

Default risk

This is the most frightening of all investment risks. The risk of non-payment refers to both the principal and the interest. For all unsecured loans, e.g. loans based on promissory notes, company deposits, etc., this risk is very high. Since there is no security attached, you can do nothing except, of course, go to a court when there is a default in refund of capital or payment of accrued interest.

Given the present circumstances of enormous delays in our legal systems, even if you do go to court and even win the case, you will still be left wondering who ended up being better off - you, the borrower, or your lawyer!

So, do look at the CRISIL / ICRA credit ratings for the company before you invest in company deposits or debentures.

Business risk

The market value of your investment in equity shares depends upon the performance of the company you invest in. If a company's business suffers and the company does not perform well, the market value of your share can go down sharply.

This invariably happens in the case of shares of companies which hit the IPO market with issues at high premiums when the economy is in a good condition and the stock markets are bullish. Then if these companies could not deliver upon their promises, their share prices fall drastically.

When you invest money in commercial, industrial and business enterprises, there is always the possibility of failure of that business; and you may then get nothing, or very little, on a pro-rata basis in case of the firm's bankruptcy.

A recent example of a banking company where investors were exposed to business risk was of Global Trust Bank. Global Trust Bank, promoted by Ramesh Gelli, slipped into serious problems towards the end of 2003 due to NPA-related issues.

However, the Reserve Bank of India's [Get Quote] decision to merge it with Oriental Bank of Commerce [Get Quote] was timely. While this protected the interests of stakeholders such as depositors, employees, creditors and borrowers was protected, interests of investors, especially small investors were ignored and they lost their money.

The greatest risk of buying shares in many budding enterprises is the promoter himself, who by overstretching or swindling may ruin the business.

Liquidity risk

Money has only a limited value if it is not readily available to you as and when you need it. In financial jargon, the ready availability of money is called liquidity. An investment should not only be safe and profitable, but also reasonably liquid.

An asset or investment is said to be liquid if it can be converted into cash quickly, and with little loss in value. Liquidity risk refers to the possibility of the investor not being able to realize its value when required. This may happen either because the security cannot be sold in the market or prematurely terminated, or because the resultant loss in value may be unrealistically high.

Current and savings accounts in a bank, National Savings Certificates, actively traded equity shares and debentures, etc. are fairly liquid investments. In the case of a bank fixed deposit, you can raise loans up to 75% to 90% of the value of the deposit; and to that extent, it is a liquid investment.

Some banks offer attractive loan schemes against security of approved investments, like selected company shares, debentures, National Savings Certificates, Units, etc. Such options add to the liquidity of investments.

The relative liquidity of different investments is highlighted in Table 1.

Table 1
Liquidity of Various Investments
Liquidity	Some Examples
Very high	Cash, gold, silver, savings and current accounts in banks, G-Secs
High	Fixed deposits with banks, shares of listed companies that are actively traded, units, mutual fund shares
Medium	Fixed deposits with companies enjoying high credit rating, debentures of good companies that are actively traded
Low and very low	Deposits and debentures of loss-making and cash-strapped companies, inactively traded shares, unlisted shares and debentures, real estate

Don't, however, be under the impression that all listed shares and debentures are equally liquid assets. Out of the 8,000-plus listed stocks, active trading is limited to only around 1,000 stocks. A-group shares are more liquid than B-group shares. The secondary market for debentures is not very liquid in India. Several mutual funds are stuck with PSU stocks and PSU bonds due to lack of liquidity.

Purchasing power risk, or inflation risk

Inflation means being broke with a lot of money in your pocket. When prices shoot up, the purchasing power of your money goes down. Some economists consider inflation to be a disguised tax.

Given the present rates of inflation, it may sound surprising but among developing countries, India is often given good marks for effective management of inflation. The average rate of inflation in India has been less than 8% p.a. during the last two decades.

However, the recent trend of rising inflation across the globe is posing serious challenge to the governments and central banks. In India's case, inflation, in terms of the wholesale prices, which remained benign during the last few years, began firming up from June 2006 onwards and topped double digits in the third week of June 2008. The skyrocketing prices of crude oil in international markets as well as food items are now the two major concerns facing the global economy, including India.

Ironically, relatively "safe" fixed income investments, such as bank deposits and small savings instruments, etc., are more prone to ravages of inflation risk because rising prices erode the purchasing power of your capital. "Riskier" investments such as equity shares are more likely to preserve the value of your capital over the medium term.

Interest rate risk

In this deregulated era, interest rate fluctuation is a common phenomenon with its consequent impact on investment values and yields. Interest rate risk affects fixed income securities and refers to the risk of a change in the value of your investment as a result of movement in interest rates.

Suppose you have invested in a security yielding 8 per cent p.a. for 3 years. If the interest rates move up to 9 per cent one year down the line, a similar security can then be issued only at 9 per cent. Due to the lower yield, the value of your security gets reduced.

Political risk

The government has extraordinary powers to affect the economy; it may introduce legislation affecting some industries or companies in which you have invested, or it may introduce legislation granting debt-relief to certain sections of society, fixing ceilings of property, etc.

One government may go and another come with a totally different set of political and economic ideologies. In the process, the fortunes of many industries and companies undergo a drastic change. Change in government policies is one reason for political risk.

Whenever there is a threat of war, financial markets become panicky. Nervous selling begins. Security prices plummet. In case a war actually breaks out, it often leads to sheer pandemonium in the financial markets. Similarly, markets become hesitant whenever elections are round the corner. The market prefers to wait and watch, rather than gamble on poll predictions.

International political developments also have an impact on the domestic scene, what with markets becoming globalized. This was amply demonstrated by the aftermath of 9/11 events in the USA and in the countdown to the Iraq war early in 2003. Through increased world trade, India is likely to become much more prone to political events in its trading partner-countries.

Market risk

Market risk is the risk of movement in security prices due to factors that affect the market as a whole. Natural disasters can be one such factor. The most important of these factors is the phase (bearish or bullish) the markets are going through. Stock markets and bond markets are affected by rising and falling prices due to alternating bullish and bearish periods: Thus:

• Bearish stock markets usually precede economic recessions.
• Bearish bond markets result generally from high market interest rates, which, in turn, are pushed by high rates of inflation.
• Bullish stock markets are witnessed during economic recovery and boom periods.
• Bullish bond markets result from low interest rates and low rates of inflation.

How to manage risks

Not all the seven types of risks may be present at one time, in any single investment. Secondly, many-a-times the various kinds of risks are interlinked. Thus, investment in a company that faces high business risk automatically has a higher liquidity risk than a similar investment in other companies with a lesser degree of business risk.

It is important to carefully assess the existence of each kind of risk, and its intensity in whichever investment opportunity you may consider. However, let not the very presence of risk paralyse you into inaction. Please remember that there is always some risk or the other in every investment option; no risk, no gain!

What is important is to clearly grasp the nature and degree of risk present in a particular case � and whether it is a risk you can afford to, and are willing to, take.

Success skill in managing your investments lies in achieving the right balance between risks and returns. Where risk is high, returns can also be expected to be high, as may be seen from Figure 1.

Figure 1: The Risk-Return Trade-Off

Once you understand the risks involved in different investments, you can choose your comfort zone and stay there. That's the way to wealth.

(Excerpt from Personal Investment & Tax Planning Yearbook (FY 2008-09) by N. J. Yasaswy, published by Vision Books.)

Published by 

http://www.rediff.com/money/2008/jun/24bspec.htm

Related:

The Sources of Risk in Stock Investing