Thoughts on Risk

Thoughts on Risk

My recent investment in Patriot Nation (PN) and the discussion surrounding the price fluctuations over the past week have me thinking about risk in investing. These are my musings for the day so I thought I would write them out and share them with all of you to help clarify my own thinking on the subject.

I remember when I was first learning about investing there were two pieces of advice which have stayed with me over the years. I don’t recall the exact phrasing of those conversations nearly 20 years ago, nor who said them, but to paraphrase:

“If you invest in stocks be prepared to see an investment drop 75% in value and your whole portfolio drop 50% in value. Even an index fund may loose 50% or more of its value.”

“Investing done properly is not gambling. Gambling is exciting because of its unpredictability. Investing is more often boring and predictable.”

Right or wrong, those statements have had a huge impact on my investing strategy, especially when combined with a bit of wisdom told to me when working as a software engineer in the aerospace industry: “Any risk can be managed and mitigated.”

Thanks to these gems of wisdom I have a hard time getting worked up about PN loosing 20% of its value after my initial investment. I’m not even particularly worried about the thought of the stock going to $0. My investment in PN is small enough I would barely notice its disappearance (yet large enough that any gains can still have an effect on my portfolio). Meanwhile I have done everything I can to understand the company to the best of my limited ability and am satisfied this is more likely than not a well run and profitable business. It was boring doing hours of research into this company yet I am now satisfied I have at least some idea of what will come in their future.

At a larger level, my whole portfolio provides risk management for the individual positions.

The majority of my investments are in IRA accounts which I will likely not touch for a minimum of 22 years. That time horizon gives lets me not worry about short-term problems. Meanwhile I am learning all I can about investing in order to mitigate the risk of my own ignorance. This will decrease my risk later in life when I have a shorter investment horizon and more immediately mitigate the risk of my own ignorance for my non-retirement investments which I may withdraw money as soon as 3 months from now or maybe not for years.

My largest positions within my portfolio are a combination of those stocks with the lowest risk balanced against higher risk investments which I understand very well and thus have a high conviction in their performance (e.g. SWKS). Quite often I would like to invest more in a company I like but limit myself in order to mitigate the risks involved.

Yet I also need to keep in mind the opportunity risk: How much money does diversity cost me when a small position has very high returns? How much money am I loosing by keeping it invested in a large company with slow and steady returns?

At an even larger level I look to trends in the world to further mitigate the risks in my investments. How is technology changing the world and what companies are set to take advantage? Not only in exciting ways like IoT or 3-D Printing but also innovations to boring infrastructure. What social trends will have investment impacts?

Another risk I manage is: what do I do with money I have not yet invested? I firmly believe in remaining 100% invested because I have no faith in my own ability to time the market. Yet because of the limits in my own investing expertise I frequently find I do not yet have any company I want to invest in. So I use index funds in place of cash, a policy which has served me well these past weeks.

I consider my own ignorance my single largest source of risk, far more than any individual investment like PN. It is for this reason that I have devoted the majority of my free time to studying investing the past three months. I have a lot of money to invest and a determination to make real investments rather than uninformed gambles. It has been a race against time in order to make good investment decisions in the current market where opportunities abound yet I am confident I have succeeded more often than not thanks to the time involved mitigating this large source of risk. Looking to the future I still have thousands of posts to read on this forum and others I have found and a growing list of books to read.

So far I am satisfied with my strategy. I consider it promising that I have not been worried about my portfolio these past two months while the market has been so troubled.

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It was boring doing hours of research into this company (PN)…

Othalan - I have to agree with that assessment - I will not be going into the insurance business. However, one thing I love about investing is it increases your knowledge of the world we all live in. It keeps you up to date on current events in the world, you learn about industries that you would otherwise never even dream of reading about, and you learn about your own values.

Thanks for the post. I guarantee many reading it go through the similar trains of thought.

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Great post Othalan. Hope you get a Post of the Day. It’s worth it.
Saul

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Saul, thank you for the kind words!

Whether Markets are More Efficient or
Less Efficient, Costs Matter
…Now for the really bad news. Investors pay their investment costs each year in nominal current dollars, but they measure their long run investment success in real dollars, almost inevitably eroded in value by inflation. The nominal long-term returns of about 10 percentage points on stocks that the financial intermediation system waves before the eyes of the naive investing public turn out to be about 6 ½ percentage points in real terms.
https://www.vanguard.com/bogle_site/sp2004AIMRefficientMrkts…

Even more boring than all-indexing on a regular basis but probably more important.

Real dollars and friction costs—this century has been absolutely terrible for the indexer. Just as low cost indexing became popular and in vogue.

Coincidence? Have no idea.

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Since you received the post of the day, I will play Cliff Clavin…

I firmly believe in remaining 100% invested because I have no faith in my own ability to time the market.

Have you ever tried timing the market? It is not that difficult. The worst you could do is match your current returns. I’ll be glad to show you how to determine the trend and determine overbought/oversold conditions.

Yet I also need to keep in mind the opportunity risk: How much money does diversity cost me when a small position has very high returns? How much money am I loosing by keeping it invested in a large company with slow and steady returns?

Any time you are invested you are risk-on. Suppose you could match your current returns but be in cash (risk-off) 6-9 months a year? Would you go for that?

Would you consider putting money in only a few ETFs for those 3-6 months a year? No fundamental analysis need. Ride that market. Only analysis is on the market. More time for golf…

Just some ideas for ya…

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ajaskey,

Thank you for the very generous offer! At the moment my time is fully committed to learning my current style of investing, however at some point in the future I will almost certainly look closer at topics such as market timing. I recognize that I still have a lot to learn about evaluating individual stocks and I want to focus on that before I consider a large new topic such as market timing.

Not to say I ignore timing. I’ve picked some very good entry points for my current investments (a task made easier by current market conditions, I admit). Before I made those purchases, I considered under what conditions I would sell all or a portion of the investment. I also shift money between investments based on current conditions. (For example, shifting money from CASY to INFN to take advantage of the recent price drop).

Any time you are invested you are risk-on. Suppose you could match your current returns but be in cash (risk-off) 6-9 months a year? Would you go for that?

I’m curious, have you considered that cash gives a risk of missed opportunities? Good news can come just as unexpectedly as bad news and being in cash means missing stock price gains related to that good news. How do you manage that risk in your investment style?

Thank you for your comments!

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I recognize that I still have a lot to learn about evaluating individual stocks and I want to focus on that before I consider a large new topic such as market timing.

Nothing wrong with that. But “learning about evaluating individual stocks” is a choice not a requirement. It is an enticing game, but not directly related to maximizing your returns. Someone always has more and better information than you can obtain.

You will make a lot more money with less effort by swing trading the major indices via an ETF (SPXL/SPXS, TQQQ/SQQQ, TNA/TZA). You can still use your macro fundamental knowledge without worrying about lying, cheating, and stealing at the company and financial institutional levels.

What is your goal? To make the most money possible for retirement? Or to make the most money possible for retirement within a “game” bound by arbitrary rules.

Is it more important to show the world you can compete with Warren Buffett or to maximize your retirement account?

I’m curious, have you considered that cash gives a risk of missed opportunities?

Never. I am up 10% YTD and if I stayed in cash the remainder of the year I will probably beat most financial products. Again, what is your goal? To beat the markets proving your smarts or to just make money?

Hey, I have been where you were. I wrote all sorts of programs to find the best fundamental stocks. After 10 years I realized that I accomplished a lot and learned even more. But, I just did not maximize my return on free cash. I have decided my goal is to make money, not outsmart the market.

Just trying to save you some time…

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How do you manage that risk in your investment style?

Good thing about ETFs in major markets is they don’t open down 20-75% when stuff hits the fan. No need to “diversify” as the ETF of the SPX is already diversified.

When I am wrong (based on Mr. Market telling me so) I close the position quickly. I don’t use arbitrary stop loss points, but that is my strategy. Nothing wrong with using a stop loss and probably safer.

Assuming the major trend is up:

I buy when SPX is very oversold. If the market remains oversold then I hold knowing that the market will eventually become overbought. In most cases I am up 5-30% at that point (SPXL is 3x leveraged). If the market becomes overbought and I am still down then I sell and take the loss. Note, you cannot do this with an individual stock or you could lose everything.

There are much better ways to do this and I am working on improving my strategy to limit losses. Everyone needs to find a good strategy that works with an individuals personality.

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Ajaskey
How do you determine oversold / overbought?
I am curious to learn

How do you determine oversold / overbought?

The easiest way is from Helene Meisler. Just track the 10 day moving average of the net advances minus declines on the NYSE. Looking back a few years will give an idea about what is overbought and what is oversold.

http://stockcharts.com/h-sc/ui?s=%24NYAD&p=D&yr=0&am…

There are many other methods of this. I’ve created my own format with additional information. But, in the end, it is just a simple 10dma of NYAD.

https://twitter.com/AndysCycles/status/706159573573324800

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