Many times I have come across the phrase “investing is risky”, particularly when it comes to stocks/securities. I don’t think this is true, in a sense that when people say “risky” they really mean to say that the risk of loss is large and therefore it is unsafe. Generally, not knowing what the risks are in a particular investment, or not having the necessary knowledge, is what makes investing in anything risky & unsafe. Warren Buffet says that “risk comes from not knowing what you are doing”. I’ll comment a bit more about that at the end of my article. First, we need to find out why people say that “investing is risky”.
Lets review what Benjamin Graham, who was Warren Buffet’s teacher, said about the confusion with the concept of risk in relation to stocks/securities (from his book Intelligent Investor):
He starts by comparing the conventional view, that good bonds are less “risky” than good preferred stocks, which are less “risky” than good common stocks.
– A bond is unsafe when it defaults on its interest or principal payments.
– A preferred stock or common stock with a dividend is unsafe when the given rate is reduced or stopped (if it was purchased with the expectation that the rate would be continued).
– Any investment contains a risk if there is a good possibility that you have to sell when the price is below the cost.
The idea of “risk” has been extended to apply to a security’s decline in price (which may be temporary or cyclical, even if owner is unlikely to be forced to sell at such a time).
Benjamin Graham compares this with an individual who has a mortgage and to commercial business. The individual might sustain a substantial loss if they are forced to sell the building at an unfavorable time. Usually that element is not taken into account when judging the safety or risk of real estate mortgages. The risk attached to ordinary businesses is measured by the chance of losing money, not by what would happen if the owner would be forced to sell.
He explains that an investor does not lose money when the market price declines. The decline does not mean the investor is actually running a true risk of loss. If a group of stocks show satisfactory over-all return over a number of years. This group of stocks is usually said to have been proved as “safe”. However, during that time its market value was bound to fluctuate, and would sell under the initial cost. Confusion now enters the picture because price fluctuation is connected to making an investment “risky”. The investment is now both “risky” & “safe” at the same time. That obviously does not make sense.
His statement couldn’t be any better:
“This confusion may be avoided if we apply the concept of risk soley to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.”
Many stocks do involve risks of deterioration, but value investors believe a properly selected investment does not carry any substantial risk of this type. They should not be termed “risky” because of price fluctuation related to the market & stocks in general. However, if the investment was over-priced compared to its intrinsic value, the risk is present even if severe price declines may be recovered many years later. Remember that time is money, so there may be loss from not being able to invest in another investment while waiting an unreasonably long time for the price to recover.
The deterioration that Benjamin Graham refers to include deterioration to the company’s position in its industry and financial health. For example, if a company was a leader in its industry, then its sales, profits, and growth are likely to be large. However, if the company loses its competitive advantage (can be due to a variety reasons) and drops from industry leader to one of a mediocre company or worse, then we can expect declines in sales, profits, & growth. This may also lead to a decline in financial health. A decline in financial health may also be caused by excessive operating costs, inefficiencies, government regulations, or additional debt (from merger & acquisition financing, or other reasons). All these factors may cause the company to deteriorate, which may eventually lead to a severe decline in its intrinsic value & trading price, or worse bankruptcy.
You can control the amount risk you are exposed to, by being knowledgeable about:
– Margin of safety
[a buffer to allow for a specific & quantified amount of error in your calculations.]
– External factors which may affect the investment.
[Economics, industry, trends, competition, etc.]
– Internal factors which may affect the investment.
[For stocks this would be the company’s financial health, efficiency, labour issues [if any], management team, etc.]
– Worse case scenario’s effect on the investment.
[Likely worst case negative scenario’s effect on the investment.]
– Intrinsic value of the investment.
[How much is the investment actually worth (not what the current selling price is). Calculate this before you make any investment.]
– The investment itself.
[How does it work, how do you purchase it, how do you sell it, how do you plan to make money from it, terms/conditions, things associated with holding the particular investment.]
– Time horizon.
[Are you going to have to sell it within a year, two years, or can you hold it for 5 or even 10 years?]
– Your own circle of competence.
[Do you have the necessary skills & knowledge, or do you need to learn more first in order to make such an investment?]
– Your own finances.
[Can you actually make this investment? Can you reasonably sustain the worse case scenario loss?]
I hope this helps put the concept of risk into perspective, & how you can manage the amount of exposure to true risk.
Thanks & Happy Investing!
The Investment Blogger ©
The Intelligent Investor by Ben Graham is available online from Amazon.ca/com. I have placed a link to the specific version/edition that I recommend. There are a few editions out, but this one has the Introduction and Appendix written by Warren Buffet (informative extra commentary). Its a very good book to use as a starting point for investing, and for veteran investors alike.