Is investing risky? The answer is yes if something is anything but risk-free. People come out saying investing in certain investments are risky, but why would they consider it risky? I will be using shares as an example today to explain risk. It is very clear that when we take higher risk, there is possibility we will be rewarded accordingly.
In general, why would we consider something risky? It may be because its outcome is very uncertain, hard to predict or even out of our control. This is exactly the same when you evaluate shares. We think it is risky when it is hard to make a good prediction that comes out right most of the time.
Okay, I have to use some financial terms, but I will put it in the simplest way. There are two types of risk a company/business faces, internal and external. It's pretty common right? Which risk is harder to evaluate? I would say the external risk because the external factors are the ones we lack control of. Internal risk are called firm-specific risk (only that particular firm faces that risk) and external risk are called systematic risk (all companies will face this risk).
To evaluate risk is not complicated, if you have some accounting knowledge, you've already know more than half of it. In accounting we use ratios to determine the well-being of a company. We use profitability, liquidity and solvency ratios. First of all, what is the worst thing that can happen to a company? I would say going bust or bankruptcy. How probable is a company going to face the worst? Well, we use liquidity ratios like current ratio and quick ratio. As most people would know, these ratios tell us whether a company is able to pay off its short term debts with its liquid assets. If it is yes, then the worst is unlikely to happen short term.
Secondly, can the business meet future obligations like interest payments in the long term? Well we use the interest cover ratio. Technical definition is"Measures the ability of the company to meet its fixed interest obligations. It equals the earnings, before interest and tax, divided by the interest paid". Usually there is a rule of thumb about 5 times as a comfortable level.
Then we also see whether a company is highly geared/financed by debt? Well it is quite obvious a company with high gearing faces a higher risk of repayments. And if the company defaults on them, they might be wound up/declared bankrupt. So there is the use of the debt/equity ratio, which calculates what proportion of assets are financed by debt/borrowings. There are many good companies which are highly geared, so it no real indication whether it is a good company or not. And we also have the earnings stability ratio to tell us whether earnings are stable enough to pay off debts and maintaining the level of dividends . Many shares are priced based on their dividends so any fall in dividends may indicate the company may not be performing well (assuming the same dividend payout percentage). And that's all for firm-specific risk. Based on the company, independent of external environment, is the company risky to invest in? Those are the few ratios that will tell you that.
And now, an equally important part, the external risk/systematic risk. Economic conditions make up most if the systematic risk any business faces. From inflation, commodity prices to consumer spending. So since every firm faces systematic risk, will it be sound to ignore it? Of course not. Everyone IS affected, but the magnitude of that effect varies across companies. In a recession or boom, the healthcare sector thrives , but does this happen to the energy sector? No, energy sector usually is cyclical which means it fluctuates according to economic activity. So is the healthcare sector less risky than energy sector? If you look at the sector as a whole then YES!. How do we measure it? The most common ratio is Beta. It "Measures the stock prices sensitivity to fluctuations of the market as a whole. A beta greater than one indicates greater volatility, and a beta of less than one indicates lower volatility, than the market". So in short, the higher the beta, the higher the risk. If the beta is 1.2. Then it means the stock is more responsive to market conditions than normal. If the market rises by 1%, then on average that stock will rise by 1.2 %.
So if an investor wants to achieve above average returns and has high tolerance for risk, a high beta stock would be ideal. If a person is risk adverse and just wants to protect capital, the person should choose a low beta stock/investment. This is also why people buy gold and silver, these metals have beta close to zero and thereby the investor is unlikely to lose any money in any market condition.
You want a higher return, then you need to undertake more risk. It also means you need to be able to withstand large swing in prices. If you can watch your holdings fall by 50% and not panic, you are ready to invest . This was one of Buffet's quotes. But think about this, if a stock has a high beta, when market conditions are poor, you get to buy it lower than it should be, and when things turn better, you get to sell it higher than it should be (compared to a stock with beta of 1). In the long term, historically, stocks head upwards, and if you are a long term investor, there is every reason you should be holding/buying a high beta stock.
In my case today, I try to achieve an above average return. This means I take a more aggressive approach. I only buy up to 5 stocks which I think are the best through my analysis. I believe if you want to outperform the market, you need the best firms in your portfolio. You can pick the best 10 or 20, but why not best 5 ? This is just a personal opinion which in my case hasn't proven to work yet but I think it makes good sense.
There's another case of diversifying. We are encouraged to diversify to reduce risk. There is nothing wrong with doing that. Have a thought about this, if you identified the top 50 firms. How many of them would you buy? Would you buy 30, 40 or all 50 firms? The most aggressive method is obviously buying ONE firm, because it is simply the best and will outperform any other company. But the problem is , it is not quite sound to put all your money in one stock (although technically right). In this case I recommend up to 10 stocks for a portfolio. The return of the top 10 firms will of course give you a better return the top 50 firms. You should remember, if you diversify risk, this would almost certainly lead to diversifying away your returns. If you seek very good returns, I would say buy up to 10 shares. If you seek security, you can do a mixture of high beta and low beta stocks and you can go up to any amount you like but just keep in mind of brokerage fees for each trade.
I think I am done with this post. Sorry I think I jumbled around the word shares/stocks/firms/business/companies, but they actually mean the same thing. I hope this helps solve some questions about risk. Please tell me of any errors you think I could have made. Again, everything are mostly based on what I went through so there could be cases that I am wrong. Anyway, I hope this was informative for everyone. Thanks for dropping by!
~deyao~
