Managing and Minimizing Risk
Risk is one of those four-letter words that people try to avoid, particularly when it comes to investing their hard-earned dollars. Having said that, it’s impossible to completely eliminate risk since all investments carry some degree of it. The key to being a successful investor is to determine the level of risk that you are prepared to tolerate, and then invest accordingly. But before doing this, you need to understand risk and the various forms in which it can appear.
Broadly speaking, risk is the possibility that the expected return on your investment may not be fully realized. This includes the possibility that you may lose some of your initial investment (also known as your principal investment). There are 5 categories of risk you need to consider when assessing an investment:
Inflation Risk: The uncertainty of the return and future value of your investment due to changes in inflation. For example, if you purchase a stock for $100 and a year later it is $110, you have gained 10% on your investment. However, if inflation increases to greater than 10% during the same time period, you will have a negative return as the rate of inflation has outpaced the rate of your investment.
Interest Rate Risk: The possibility that a rise in interest rates may dictate a drop in the value of your investments. For example, rising rates can make dividend earnings on current investments less attractive as the cost of borrowing is higher for companies meaning that they are less encouraged to spend and give out dividends.
Economic Risk: The danger that a downturn in the economy, or other significant economic event, will depress the value of your investments by reducing your earning capability (potential profit).
Market Risk: The possibility that events in the market itself may have an adverse effect on the value of your investments.
Specific Risk: This relates more directly to the individual investment itself. It covers such elements as new technology making a certain firm’s products obsolete or greater competition reducing earning capabilities.
With a greater understanding of the various forms of risk, you’ll be in a better position to find ways to help reduce risk. However, there are other ways to reduce risk in a volatile market that we will get into.
Managing Volatility and Risk
Volatility has always been, and will always be, an integral part of investing. Without volatile markets, the opportunity for profit would not exist. The problem is that everyone loves upside volatility but hates downside volatility. Unfortunately, one cannot exist without the other.
To most investors, volatility means the risk of losing part of the principal invested in a stock.
The best assumption to make when initially buying any stock is that the stock will fall in price at some time during the period you hold it. It could go straight down immediately after purchase or it may not go down for several months. But assume that it will go down sometimes. When it does, will you sell the stock, buy more shares, or just sit there and watch it fluctuate? This is best answered before the original purchase is made rather than at the time the stock first falls below your purchase price. The key is to anticipate your response to the drop in price and be prepared to take action without getting caught up in the emotions of the moment. Doing so helps you avoid panic selling and missed opportunities! One way to manage this volatility is by developing a diversified portfolio.
One important thing to keep in mind would be diversification of your portfolio. Diversifying in its simplest terms means investing in multiple areas in order to hedge (reduce the risk of unfavorable price movements) the risk of certain stocks. This reduces the potential impact of stocks from a single industry falling all at the same time and you losing a substantial amount of your investment. For example, if you are going to invest in high-tech, “new-economy” stocks, include them as part of a portfolio that contains other, more stable stocks.
A well-diversified portfolio contains many stocks in different industries. That does not mean that you should buy mainframe computer manufacturers, semiconductor companies, software companies, Web retailers, etc. Even though each of those may be considered a different industry, they are merely branches of the same tree. When lightning strikes the tree, all the branches may fall!
Instead, include one or two stocks from financial, energy, healthcare, retail and other unrelated industries in a portfolio. Then, when downside volatility strikes one industry, the impact to the entire portfolio may not even be noticeable if the other stocks are rising in price.
Assume that, as part of a diversified portfolio, you own several “new-economy” stocks that have fallen in price. If you believe in those companies for the long-term, you should consider buying more shares while the price is low. Most investors want to see stock prices continually rising. What they should want are falling prices when they decide that they want to own a stock. If the stock was a good value at the higher price, it is a better value at the lower price. The lower price will allow an investor to buy more shares and further benefit from higher potential appreciation should the stock reach its expected intrinsic value.
On the other hand, you may have made a mistake. The best and brightest investment professionals make mistakes in spite of their extensive financial statement analysis, conversations with company management and years of experience as stock pickers. Decide, before you buy, under what conditions you will sell if the stock price falls. Generally, a falling price without an underlying change in business fundamentals is not a good reason to sell. If the price falls as a consequence of a change in the expected growth rate of sales or earnings, this may be a sufficient reason to sell. Establish some parameters before you buy that can provide the reasons for you to sell the stock.
Knowing some of the options available to you so that you can make an informed decision with a minimal amount of emotion. This will make stock investing and the Student Challenge a much more enjoyable and profitable experience!
Investing in Quality: Systematic Investing
As history has proven, equity investments outperform all other financial assets over the long term. So, why is it that some people’s investments perform poorly, even in years when the stock market on the whole is producing stellar returns? To suggest that these investors have simply invested in the wrong companies is unfortunately only half the answer.
For those who have not met with success investing in equities, the problem can usually be traced back to their investment style, or lack thereof. Instead of using a systematic investment approach, they often treat the stock markets like a lottery or gambling casino. Such investors may purchase a company’s stock based on a tip from a friend or relative. Or they may have read an article in the financial press, or elsewhere, about a certain stock that has doubled in price over the last few weeks, and in a rising market, they conclude that if they do not board the bandwagon, they will miss a rare opportunity. These people rarely read fundamental research. Indeed, in the worst case, they may not even know which business their new investment is in. Obviously, this haphazard approach is not the best way to realize meaningful capital gains over the long term.
An alternative approach is systematic investing. This involves a number of steps. An investor must set realistic long-term goals for both the desired rate of return, and the amount of risk acceptable in achieving this return. But most importantly, systematic investing involves selecting well-researched, high-quality stocks and taking the time to understand the fundamental factors affecting the companies in which investments have been made.
Quality stocks share several common characteristics. They are in stable businesses with good growth prospects. They are in sound financial condition, with a good history of earnings and profitability. Their management is experienced and successful. Although returns cannot be guaranteed, over the long term these blue-chip companies may be expected to match, or even outperform the general markets
When is it time to sell your Winners (or Losers)?
Investors are constantly bombarded with advice on what to buy. Rarely though, does anybody talk about the often more difficult decision of when it makes sense to sell an investment. When good quality stocks are making gains in the market, the general rule of thumb is “let profits run.”
When your investment performs poorly, the decision on when to sell gets even trickier. Human nature gets in the way, and we either don’t want to admit we made a mistake buying the stock in the first place, or we hope the stock will come back in the near term. Unfortunately, time and time again, poorly performing investments can usually be tied to deteriorating fundamentals and therefore, a loss will just get worse over time. Rarely do these deteriorating situations turnaround.
As a consequence, we end up holding on to poorly performing stocks much too long, watching them sink ever lower. An effective way to prevent hanging on to these underperforming investments is to set up a “stop loss” point. This means predetermining a price at which you sell your investment. Having this fundamental base to work from makes the decision of when to sell, or when to hold, much easier.
Avoid Common Investing Pitfalls!
Although the Student Challenge is a 3-month competition, your goal is to construct a portfolio based on sound investing fundamentals. You’ll have the opportunity to explain your investment strategy in a 500-word written thesis. We highly encourage you to put some thought into designing your investment approach and avoid some of these common pitfalls.
When it comes to preparing our financial future, we all have the best intentions. We research the safest investments, we read magazines and books, we attend seminars and courses. All in an effort to find the path to financial wizardry.
But there isn’t any yellow brick road, and the route to financial security is strewn with pitfalls. Few financial success stories are without episodes of failure. The trick is to keep those failures to a minimum. Consider the following tips from our friends at CIBC Investor’s Edge:
Not Setting Goals: It can be difficult to find the right advice or the right products when you’re not clear on the direction you want to head. Setting a goal is fundamental. Consider your circumstances, as well as your future financial goals. Define your goals as clearly as possible, and set specific objectives as certain reference points along the way.
Procrastination: If you don’t have definite goals, you’re not likely to get excited enough about financial planning to get yourself started. In short, don’t keep putting off your financial future.
Missing the Big Picture: If your plan is to be workable, you need to look at all aspects of your financial situation and how they interrelate. And be sure not to neglect key considerations such as the tax aspects of investment decisions, or concentrate on short-term objectives at the expense of long-term dreams.
Too Attached: Try not to get attached to any investment decisions you make. Learn to cut your losses and take your profits when opportunities permit. One of the best ways to take the emotional involvement out of the process is to develop a disciplined approach to your portfolio management. Disciplined investors rebalance their portfolios periodically, with a very simple goal in mind: buy low and sell high.
Don’t Follow the Crowd: Most investors enter the market at the wrong time. Investment fads change from decade to decade, or even year to year, but human nature remains constant. Try to keep your focus on your own goals and needs.