Aug 142014
 

The level of financial risk we can tolerate depends on our savings: The less money we have the more risk we can afford to take on. If you have worked with a financial advisor before then you’ve probably seen a risk tolerance chart like the following.

14-08-risk-tolerance

Each portfolio from A to D represents a different risk tolerance of maximum expected returns and losses. Choosing a model portfolio can help one’s financial advisor determine the best funds for the client based on his risk assessment. Conservative portfolios tend to hold more bonds, GICs, and T-Bills. Aggressive portfolios may hold more technology and energy stocks, which are more risky but also more potentially profitable.

If we are currently in our working years and only have $100,000 of savings, then we should have an aggressive investment plan that mimics the expected rate of return as Portfolio D in the image above. High risk, high reward. Like Ms. Frizzle always says, “take chances, make mistakes, get messy!” This is because losing $20,000 in the worst case scenario is no big deal since we are still actively working. $20,000 is only 6 months worth of salary for many people, so the loss can be quickly recouped :D But if things go well then hot diggity dog! we’ll make a $50,000 profit. The key to compound interest is to start as early as possible so if we can make our portfolio value 50% higher at a younger age it will give us a huge advantage over the long run.

14-08-invest-balls

But if we have recently retired and have $1,000,000 in savings then our investment goals would be different. We can’t be in Portfolio D because a potential $200,000 loss is a lot of money, and could prevent us from having a comfortable retirement. At the same time the potential return of $500,000 doesn’t sound that appealing when we’re already millionaires. At a certain level of wealth any extra money we save will face diminishing marginal utility which means the lifestyle of a senior who is worth $1.5 million isn’t going to be drastically different from another senior with only $1 million. So in this situation it would be better to choose the more defensive Portfolio A.

When we’re young our spending often depends on the product of our human capital and time, both of which we have an abundance of. But when we’re retired our human capital becomes diminished, so lifestyle needs to depend on our savings instead. This is when capital preservation takes priority over investment returns and we have to decrease our exposure to risk in order to make our portfolio last as long as possible ;)

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Random Useless Fact:
Humans don’t have natural enemies. So we fight with each other.

 

Dec 112012
 

One myth about investing in the stock market or any other market where prices fluctuate is that it’s risky. But people who know how to value a stock understand that it doesn’t have to be risky if they buy the right stocks at the right time. Volatility and risk aren’t always correlated. Some companies with steady growth such as Enbridge have been pretty stable over the years.

Enbridge stock chart, volatility and risk

That’s not to say ENB is a good buy today because whether a stock is reasonably valued or not is another topic. But here’s a look now at Caterpillar below, who manufactures construction equipment, heavy machinery, etc.. Notice how the stock is more volatile over the same period as Enbridge.

Caterpillar stock chart, Volatility and Risk

But that doesn’t necessarily mean CAT is a riskier stock than ENB.  CAT is a more cyclical company so its Beta is suppose to be higher. What makes a company safe to invest in for myself is a positive trend of earnings growth, dividend growth, and industry expansion. Both companies have had stable dividend growth over the last decade meaning managers are confident about their company’s future performance. Both companies have also increased their profits over the years. Pipeline companies are looking to expand their pipes across Canada, and In Alberta alone the government has forecast there will be 114,000 jobs in the construction industry over the next decade (o.O) ENB and CAT are both in growing industries with growing demand for their products/services.  Stocks can vary in risk depending on what kind of business they are, but volatility doesn’t necessarily mean risk. It just means at some point in time, there might be  a good opportunity to buy the stock at a great value ;)

Here’s what the Oracle had to say on the subject….

“Volatility does not measure risk. Past volatility is not a measure of risk. It’s nice math, but it’s wrong. If a farm in Nebraska used to sell for $2,000 per acre, and now it sells for $600 per acre, investment theory would say that the beta of farms has gone up, and than they are more risky than before. If you tell that to people, they’ll say that that’s crazy. But farms don’t trade daily the way stocks do. Since stock prices jiggle around, finance professors have translated that into these investment theories. It can be risky to be in some businesses. Risk is not knowing what you’re doing. If you know who you’re dealing with, and know the price you should pay, then you’re not dealing with a lot of risk. We have invested in a lot of sectors that have high betas. The development of beta has been useful to people who want careers in teaching.”
- Warren Buffett

Beta – The measure of volatility. Higher beta = bigger fluctuations in price. The overall market has a Beta of 1. If a stock is said to have a Beta of 1.5 then that means it will be 50% more volatile than the market.

Apr 092012
 

If you’re not familiar with how margin accounts work, you can read this other post first. We’ve already seen how a margin account is similar to getting a mortgage or a home equity loan (HELOC.) Today we’ll discuss margin loans and how to avoid a margin call.

A conventional mortgage requires a 20% down payment which means the bank is willing to give out 80% loans. Why 80% and not 60% or 100%? Because a 60% loan doesn’t make them as much money and 100% is simply too risky. It’s not practical for people to buy homes with 0% down. What if the home’s value drops and the buyer walks away? Margin accounts work in a similar way. Lending is based on the risk that banks are willing to take. So how much money can we borrow in a margin account?  The actual answer is it depends on what stocks we buy. Some stocks are relatively safe, but others are extremely risky. So banks have organized stocks into a few different lending groups. The safest, defensive group will have a 70% lending value. More risky companies will get a 50% or lower lending value, and for the really risky companies, 0%, (ie: we can’t use any margin money to buy them.) Stocks are always moving so sometimes a company’s lending value will change from one group another, but the bank will notify their clients if this happens. Each bank should have a list of stocks and their respective lending values.

If it’s risky for the banks to lend us money to speculate on stocks, then why do they even offer this service in the first place ಠ_ರೃ ? The reason is the same for why banks give people mortgages. For us, a margin account is a way we can use leverage to increase our profits in the stock market. But for banks, a margin account is a debt instrument they use to earn recurring interest. If we buy stocks using more money than what we deposited in our margin accounts we have to pay monthly interest to the bank on however much money we’ve borrowed. So banks want to make money, but they have to be careful not to take on too much risk. Just like a mortgage, banks don’t care if the price of our stocks (or homes) appreciate or not. They only make money on the interest from lending us money.

The amount of available margin money we can borrow fluctuates everyday because its based on the market value of the shares we hold. If we have $100,000 worth of stocks today with a 70% lending value then our available margin is $70,000. But if the market value of our stocks dropped to $90,000, then the bank can’t lend us $70,000 anymore because $70,000 of a $90,000 asset is 78%. That’s higher than 70%, which means too much risk. So at $90,000 our margin amount changes to $63,000. So we should never max out our margin usage in case our portfolio losses value. As soon as the lending amount crosses over 70% we would get a call like the following “hello, this is your broker, could you please put more money into your account or sell some stocks to bring the lending amount back down to 70% or below.” If we ignore this margin call and don’t take any action, then the broker will sell our stocks for us because if we leave the country and our stock goes to zero, then they are on the hook for that $70,000. Selling our stocks is how banks and brokerages protect themselves.

The way I like to use margin accounts is to buy stocks on margin but not borrow so much that I’ll risk getting a margin call. So if the maximum I can borrow is 70% of my holdings then I’ll only borrow up to 40% or 50% so I have some extra margin wiggle room. Later this week, I’ll walk through a recent transaction in my margin account (゜∀゜)

 

conventional mortgage - a mortgage that isn’t more than 80% of the purchase price of a home.
lending value - this is the “up to” amount. 70% means a maximum lending ratio of 70% but we can borrow less if we want to. Note: US and Canadian lending values are different due to separate regulatory bodies. A list of 70% lending value Canadian companies can be downloaded here (PDF.)
margin call - When the broker demands the investor deposit more cash into their account to cover possible losses. Investors can also sell their existing shares which will increase the cash amount in their accounts. Either way, the point is to decrease the lending value back to a safe amount.