Diversification
October 29, 2018
Mean Reversion
October 29, 2018
The Risk Hierarchy
Every investor seeks the Holy Grail – an investment strategy that is low risk but high returns.
After 20 years as an investor, Steve said that successful investing is more about avoiding losses than it is in trying to find the next big winner. Risk is about losing. Warren Buffett’s first rule is “don’t lose money” and the second rule is “remember rule number one”.
Investing is about outlaying money today with a plan to get more back in the future, however short or distant that future may be. When we speak of risk, we are really taking about possible future outcomes. Risk, in order to be useful in investing (or in most situations) must firstly have context to it. In other words, it is a subjective proposition rather than an objective (number based) one. Most investments are not a 50/50 proposition. Horse racing, casino games, poker are about finding asymmetrical bets. Asymmetrical means there is a difference between the pay-off probabilities and the risk. A hand of four aces will see you bet heavily in poker, a pair of three’s…ah, not so much. That requires us to look and wait patiently for situations or investment opportunities that are asymmetrical. That is, there is plenty of upside if you are right but only a little downside if you are wrong. Sam Zell, a US billionaire from real estate investing explains it like this:
“Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have to do any work is when you have a big downside and a big upside”.
I love this statement so much he has it as his photo backdrop on his twitter page. Professional punters, poker players, or experienced investors look at the “odds” (risk based on the contextual probabilities) in relation to the potential pay-off before placing their bets. As Sam says look for big upside with minimal downside. So how do we do it?
Firstly, the risk of buying the whole market is less than buying a single stock. If you immediately think “well, yes but the returns are lower” then I want you to go back to the start – it’s about not losing money. Remember most money managers underperform the index.
Here’s the rub:
- 2 out of every 5 stocks are a losing money investment (39%)
- Nearly 1 out of every 5 of stocks lost at least 75% of their value (18.5%)
- 64% of stocks underperformed the Russell 3000 during their lifetime
- A small minority significantly outperformed their peers
- Fat tails – 1 out of 5 was significant winner and loser
So to borrow a line from Dirty Harry – “Are you feeling lucky punk? Well are ya?” Index returns may be lower, but so is the risk! I use what I call the risk hierarchy. With an adequate time horizon the least risk is probably achieved buying “the whole market”. All stock markets crash, but most, if not all, recover in time. So if I can produce a risk hierarchy for investing it would look something like this – going from low risk to high risk.
- Purchasing all countries (a global) indexes ETF;
- Purchase a single country index using ETF’s;
- A single sector/industry/style using ETF’s;
- A portfolio consisting of individual stocks;
- A single company’s stock.
This is not set in stone as there are many permutations, but it at least provides some framework for assessing potential risk and returns. This is why Buffett says that if you don’t know what you are doing, buy an index – reduced risk. Rather interestingly, the returns that you can generate from purchasing a single country’s index or a single sector can be quite substantial. And the risk is much reduced from buying a portfolio of individual stocks. Have a look at the following chart. Pay attention to the returns for each of the countries. They are impressive to say the least. And most are delivered when in the previous year they were hated (remember buy low, sell high).
There are only a few question you need to think about rather than plough through a company’s last 10 annual reports. For starters, even asking yourself the most basic questions such as, will this country go bankrupt is enough to give you a good understanding of the level of risk (hint: they seldom do).
You can apply the same method to sectors. Sectors fall in and out of favour. But that does not make them riskier simply because everyone loves Information technology but not energy. My point is again to remind you how important reversion to the mean is in investing. It is also a reminder that buying assets when they look terrible (buy low, sell high), and have performed badly usually go on to outperform the “best” and least risky assets.
Of course you are welcome to try and pick a single stock (in fact pick 10 or 20) from the market of over 3000, but you must understand the risk involved in investing in each one. You can choose to build wealth fast, but this usually means taking more risk – either by chasing longer odds or increasing the bet. Big upside, big downside. Or you can see risk as not a single event, but in a hierarchy. One that builds wealth steadily while adopting low risk positions. Not the Holy Grail…but it might help you get there.
*ETF – Electronically Traded Funds and they are a basket of stocks, countries or commodities put together in one “fund” and sold to investors. They can be traded daily on the stockmarket which gives them good liquidity.
