Jun 302016
 

Brexit Raises Risk of Global Recession, Maybe

After Britain voted to leave the EU last week stock markets around the world became very volatile. Two days after the vote $2.5 trillion were wiped from the world’s markets.😱 To put that into perspective that’s roughly the entire annual economic productivity (GDP) of the United Kingdom.

George Soros, the investor who warned of a 20% devaluation in the British pound now warns the Brexit has “unleashed a crisis similar to the financial panic of 2007 and 2008.” He says that a hard landing in China is “practically unavoidable.” And he is not alone. Most news sites say the Brexit fallout will continue to ripple across the world and put not only Britain but also the U.S. and other countries back into recession.

These commentaries are often portrayed as conventional wisdom, but that doesn’t mean they are necessarily true. In fact, news predictions are often wrong. One day in 1987 stock markets around the world crashed starting in Hong Kong and spreading to Europe and then to North America. The Dow Jones index in the U.S. lost more points in a single day than any prior trading period. This historic event was known as Black Monday. Many analysts and publications at the time warned it was only the beginning of a bear market and that more turmoil would come. A lot of people believed the hype and got out of the market because they were afraid. But those investors didn’t do their own risk assessment. Today, Black Monday is nothing more than a small, insignificant blip in the historical stock market chart. (circled in red below)

16-06-1987-stock-market-crash

The way we perceive risk is not always rooted in reality. An article in the Chicago Sun-Time features a study that demonstrates how conventional wisdom can lead people to the wrong conclusions about risk. Imagine an 8 year old girl has 2 best friends who both live close by but in different homes. The first friend’s parents keep a gun in their home.🔫 The other friend’s household doesn’t have a gun but does have a backyard swimming pool. 🏊

If you had to choose, which is the safer house for the little girl to go play in? 😁

Without any other information most parents would probably think the second friend’s house is safer because guns are perceived to be more dangerous than swimming pools. But in a country such as the United States, there are about 6 million swimming pools, and 550 children under ten years old drown in them each year. However out of roughly 200 million guns in the U.S., only 175 children die each year from guns. In other words, the risk of the girl dying by a pool (1 in 11,000) is much higher than dying by a gun (less than 1 in 1,000,000.) According to the study’s author, most people are “terrible risk assessors.” We often let irrational fears cloud our judgement.

16-06-irrational-fear-pool-shark

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Apr 152016
 

This is a guest contribution from my friend Ben Reynolds at Sure Dividend.  Sure Dividend uses The 8 Rules of Dividend Investing to find high quality dividend growth stocks trading at fair or better prices.

Successful investing can be simplified into two aspects:

  1. Maximize returns
  2. Minimize risk

Point one could not be more straightforward.  The more money you make from your investments, the better.

Minimizing risk sounds straightforward, but in practice it is much more complex.  This article takes a look at the ‘standard’ risk measures in the stock market – and whether they are truly useful in reducing risk.

Common Stock Market Risk Metrics

The words Beta, standard deviation, and volatility are often used to describe the risk of individual stocks.  These financial metrics are the backbone of stock market risk measurement.

Beta refers to a specific securities’ sensitivity to overall stock market moves. A Beta greater than 1 shows more price sensitivity. If the market declines by 10%, one would expect a stock with a Beta over 1 to decline by more than 10%.  Alternatively, if the market goes up by 10%, a stock with a Beta greater than 1 would see gains of greater than 10%.

Stock price (return series) standard deviation is the most commonly used risk metric. It is calculated as the annualized stock price standard deviation of a given security.  It measures how ‘bouncy’ returns are.  The more big swings there are in the return series, the greater the stock price standard deviation.  Volatility is the same as stock price standard deviation.  It is another word for the same idea.  Volatility and standard deviation are synonymous in investing.

Fun with Numbers

Everything is a nail to a man with a hammer. Similarly, finance professors like to come up with nice tidy formulas for messy real-world problems. Beta and volatility are proxies for risk. The idea is that riskier securities will see their prices move up and down more.  This means that beta and volatility can measure underlying risk in theory. In the real world, this isn’t true.

Here’s a nice thought experiment:  Imagine you have your pick to invest in 2 different businesses at equal prices. One business makes $1,000 a year every year like clockwork.  The other business makes between $1,000 and $5,000 a year every year. Any rational person would pick the second business even though it has more variability (‘risk’ as academics see it) in its returns. In the stock market, the business that makes $1,000 a year would almost certainly have a lower beta and standard deviation than the $1,000 to $5,000 business because its returns are more ‘stable’.

What Risk Really Is

Real risk can’t be quickly calculated with stock price data. Real investing risk comes from a permanent impairment (loss) of your investment. When you are investing in businesses (stocks), you can understand risk far better by qualitatively analyzing the business.

Is Coca-Cola (KO) less risky than a biotech startup?  Most certainly.  Can I say it is 3.2x less risky?  No, because qualitatively I know Coca-Cola’s business model is proven, but I can’t put numbers to exactly how less risky it is than an unproven biotech startup.  You can say it is much less risky, however.

Some people like precision and exact numbers.  I certainly do.  But you can’t always have them.  Sometimes using exact numbers leads to worse results because the numbers don’t mean much.

Continue reading »

Jan 282016
 

What Does Risk Mean?

It’s time again to learn about you, the readers. :D  Awhile ago visitors of this blog were asked which word first comes to mind when they hear the term, “risk.”  Here are the results. Thanks to everyone who voted.

16-01-poll-risk-first-thing

It appears most readers associate risk with uncertainty or opportunity. I would choose uncertainty as the first thing I would think about when facing or talking about risk. Opportunity would probably be the next thing I would think about. Opportunity and loss can both derive from uncertainty but financially savvy people are usually cautiously optimistic about the unknown and we try to seek out serendipitous possibilities. Investors have to think like heart surgeons; 💙 we must never bypass a good opportunity.😆 As Winston Churchill once said, “a pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”

Usually the best chance we have at success also comes with a good amount of risk. But the good news is we can lower the risk without diminishing the potential gain. 🙂 We can lower risk through self knowledge and an understanding of the financial world. A lack of wisdom leads to risky behavior. As Warren Buffett once said, “risk comes from not knowing what you’re doing.” That’s why countries that are less financially literate tend to have a less affluent population. People who work in business and investment banking understand how finance works, and not surprisingly they tend to make a lot of money in their fields. The more we know, the less likely we are to fail, and the less risky our decisions will become. 🙂

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Random Useless Fact

According to the BBC, in some parts of Australia, 90% of koalas are infected with STDs. Koalas are at risk of becoming extinct because over half of them have chlamydia.

16-01-koalas-chlamydia-extinct-what-meme

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 😀 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.