Let’s talk about risk
The Greedy Farmer was talking to a friend about putting together this investing service. The friend, let’s call him Ace…since his name is Ace. Ace said “I’ll bet you avoid risk when investing”. I didn’t respond, this is a long conversation meant for another time, I thought. “My returns are poor”, Ace went on to say, “let me know when you have the service up and running…”
This conversation stuck in my mind. It was not that Ace said something radical or even memorable, it is how this statement is so unlike the way Ace runs his professional life, that made the statement stick with me. Ace takes on the most demanding, technical, and risky aspect of his industry.
Because Ace is focused, knowledgeable, careful and good at what he does, he de-risks a tough job. Ace is a dirt contractor but he specializes in bridges where he makes his best profits. Because few competitors take on the inherent risks of bridge construction and focus more on general dirt moving, Ace operates where the profit opportunity is greatest; few competitors want to take on his niche. Investing, is not different. It is not really possible to make outsized profits unless you take on the risk of capital loss (stock price decline). The companies you invest in would not need your money if there was obvious and easy money to be made. Banks step up for those low-risk opportunities, after all, no independent investors needed! Ace implied that I would be making money by avoiding risk. In actuality, I make money by taking on risk AND by managing that risk effectively.
Let’s consider a few various forms of risk (there are many more than reviewed below). The risk Ace is referring to is the risk of a capital loss. In actuality there are many kinds of risk and you are never able to avoid them all. At the risk of boring you to death, let’s look at some brief examples of several types of risk:
Inflation risk – generally a guaranteed risk* – your money will be worth less in a year than it is now
Opportunity cost risk – your investment may not fall in value but will make less than it may, invested in another opportunity.
Capital Loss risk – a stock that falls in price – an example of capital loss. This is the form of risk that receives all the attention
Liquidity risk – the risk that funds that are needed for an emergency are not available when needed. This results in an opportunity missed or borrowing costs or penalty fees incurred to unlock funds.
Let’s also consider how humans interpret risk (damn humans…so complicated) using the 2-4-2 stock portfolio performance profile. After the so-called investment period is over, your attention quickly goes to the two stocks now worth $50.00 each, right?? Maybe you recognized they were losers and sold them before they halved in value – either way, they stick out. You may even say, with the two stocks which shot the lights out plus the four stocks that did well, I would have created spectacular gain, had I not had the two losers! You may well forget; the two losers were part of the process that gave you the overall 22% gain.
The conclusions you draw now, in hindsight, that make it obvious that the losers were not quality bets were not easily seen at the start of the investing period.
Beyond the 2-4-2 portfolio, look at those other risks. The ones you have already forgotten about. If your cash was sitting in a high interest savings account paying 1.6%, you likely lost ground versus inflation. The truth is, the high interest savings account is guaranteeing a loss in “real” terms! [This is a real loss since 2.5% inflation loss minus 1.6% interest gain = 0.9% real net loss]. Or maybe you locked your money into a non-redeemable GIC which paid 2.5% interest. This rate of gain kept you even or ahead of inflation, likely, but you may have given up liquidity. Liquidity loss introduced another form of risk. During the investment period, if you suddenly needed cash, the funds locked up in the non-redeemable GIC would NOT be available, those funds would be frozen, not liquid. Funds needed would have to be borrowed at a higher rate or found from some other source. Also, the GIC investment created an opportunity cost risk. Those funds, which could have been added to the 2-4-2 portfolio earning 22% return, instead were earning 2.5%. 22%-2.5% = 19.5% opportunity cost. This does not mean holding some funds in a GIC or high interest savings account is a bad idea. You simply need to realize you are always taking on some sort of risk. We all need to be aware of all the risks and do our best to manage accordingly. As an aside, in today’s market, January 2020, where capital loss is a very real and present risk, it makes a LOT of sense to hold significant funds in interest savings accounts and GICs. Again, be aware of current risks, of all kinds, and adjust for the situation as best you can.
Even more about risk:
Know Your Client Questionnaires and discussions are an important starting place to explore the super important topic of risk. I don’t feel they are more than a starting point. For one thing, the issue of inflation isn’t even reviewed in many cases, this seems like a huge oversight. Generally the questionnaires use a somewhat tired old model. They often suggest, for example, if you feel you are a conservative investor, a 75% fixed income portfolio fits. This is such a simplistic exercise for such an impactful decision. When you consider many fixed income portfolios, a couple years ago, generated less than 3% annual total returns over 3 years and less than 4% over 5 years and, by some measures the inflation rate was over 2%, your investments were not growing much. If you were withdrawing funds at all, your buying power was shrinking! There is more risk involved in this approach than is obvious.
An example is shown below. The source of the chart is Yahoo Finance and it shows the iShares (Blackrock Canada) Canadian bond universe ETF. Total returns – which are returns that include the price gain as well as accumulated interest and / or dividend yield, reinvested – calculate to a 2.49% total gain over a 3 year period and 3.65% (per annum) over 5 years. True to a conservative positioning, this holding would not likely lurch lower at the time of a stock market plunge, yet, to have 75% of your holdings gain so little, that hardly protects against future inflation, unexpected expenses or other unknown events. By that measure, this portfolio is still carrying risk.
My point really is, you need to acknowledge there is always risk and make some adjustments for the economy we live in today and also adjust for the financial risks in your personal life. A simple formula or a number of boxes on a questionnaire will create a false sense of security and is not likely to serve you well. The Greedy Farmer portfolios adjust to current economic conditions as much as possible. You can copy the Greedy Farmer’s moves or modify category weightings to suit your perceived risks and to your risk appetite (see below). There are times I am more comfortable holding significant cash or near cash holdings, (GICs, T Bill ETFs, and high interest savings) in addition to specific bonds suited to the economic environment. Just a few years ago, conditions were different and stocks made up 95 – 97% of holdings in the Greedy Grower. The greater world changes a lot over time as does your personal world. Know Your Client information should be updated to reflect these changes. Most importantly the Know Your Client process should be allowing you to teach yourself about risk rather than providing you with the impression all is taken care of. What is that old saying, “no one cares about YOUR money more than YOU?” Keep reading, if you will, let’s explore how to make you more effective at caring.
There are two more important issues to talk about which will help you become more effective at caring. How well does a questionnaire measure your comfort with risk taking? I would argue, it does a horrible job. Like most things with some complexity, you have to EXPERIENCE risk and then evaluate yourself. Secondly, risk is a characteristic of investing to be managed, it can not be avoided. That discussion is poorly covered by the know your client (KYC) questionnaire or interview.
If you are new to investing or new to successful investing, you need to learn how to manage and accept risk through experience and the following approach should help get that done. This approach is all about understanding and developing your risk appetite.
- Start small, start with a portion of your investable holdings:
- For example, take $10,000 – $20,000 and, over 6 months – 18 months, invest in 6-12 Greedy Farmer small cap and/or value stock picks. See how you handle this. Then you will better know what your risk appetite is. Your risk comfort may change over time.
- Whatever you think you should do, especially if you feel emotional and excited (or depressed and anxious); invest half of what you think you want to invest. This sounds funny, I know. Investing is so emotional, however. When you are all excited about buying $2,000.00 worth, automatically cut that in half and buy $1,000.00 and take a break. Re-assess a week later, before you do the other half. Often the Greedy Farmer recommendations will be for a partial order anyway, with a follow-up recommendation days, weeks, maybe even months later. You can just follow that guidance. Yes, you may miss out on some gain. Sometimes you even miss out on a second purchase when stocks leap up in value. Do not sweat that. There are dozens of good stocks out there. Another opportunity will present itself.
- Re-balance at least every six months. If you chose 10 stocks, each one is worth 10% of your investing portfolio, when a holding hits 20%* of the value, sell 25-50% of that holding, depending on Greedy Farmer recommendations. Sell sooner if Greedy Farmer advises. A sell recommendation trumps a re-balancing sale.
- *Generally, any single stock holding should never represent more than 5-7%, 10% at the very most, of our total investment holdings (all accounts). I referred to higher numbers in bullet “3” above since I am assuming you are just starting out with that initial portfolio of 10 stocks of $1,000.00 each. So we need to use percentages that fit a start-up portfolio and diversify further as the portfolio grows.
Focus on the weekly portfolio total. Obviously when you are newly buying stocks, you may be checking the prices daily but do your best to look at the portfolio total. That is what you are building after all. It is a total portfolio, not just a collection of stocks. The Greedy Farmer does not like the bank apps that give you minute to minute re-pricing of your stock list, visible at-a-glance. This type of bank application just revs up the emotions, it does nothing for encouraging good investing behavior or developing a healthy risk tolerance.
Once you know what your risk appetite is, then you can build out your plan more completely. If you are super excited about your holdings, or super anxious, both may equally be signs your should consider yourself risk adverse. Too much emotion positive or negative is bad. A good sign, on days markets are falling, you are happy as you know you can nibble on (buy) some bargains…
If you find you are quite emotional, this is simply too stressful, you may want to stick with Mawer or Steadyhand mutual funds or, possibly my dividend growth stock choices, and avoid the Small Caps. This is not to say you can’t develop a healthy tolerance for risk, but maybe a more gradual approach is needed to get you there. The reason I do suggest the more volatile small caps first, you need to understand and develop your risk tolerance. The more active small caps will help you do that. Use a relatively small amount of money so the drama is within comfortable limits.
The next time you are asked what your investing goals are. You still will think, my goal is to make money and not lose money. The difference will be, you will now understand how you feel about risk, how to manage risk. No survey will get you to this spot.
Spend the money your money makes, don’t spend the money!
The not-so-fine print
- Layer yourself into positions – in most cases – that is why a lot of Greedy Farmer Alerts recommend a partial order, to be followed by additional orders
- Be aware, if your portfolio is small in value, even a $9.99 discount brokerage trading fee will do a little bit of damage to your earnings. Balance the way you layer in with the number of trades you make.
- Do not allow a single stock holding to make up more than 7% of your total holdings
- Do not allow a single mutual fund or ETF to make up more then 25% of your total holdings
- Don’t assemble your portfolio in a short period of time. It may take you 12-18 months to sell your other holdings and move to a Greedy Famer portfolio. You may even choose to do this over three tax years, if capital gains are an issue.
- A hold period, for any single security, will often be 3-5 years, or more, occasionally less. Stocks may fall after purchase but it is expected, most will be up after 1-3 years. Patience will be required. Sometimes the purchase thesis doesn’t develop and stocks are suddenly sold…mistakes are made and must be corrected for.
- In The Greedy Farmer’s Personal Portfolios, purchases are often split between registered (TFSA or RRSP) accounts and a cash (non-registered) account.
- Limit orders are almost always used. You do not want to be at the mercy of a sudden stock market price lurch. If you place a “market order” and the market spikes, you may significantly overpay or sell far below your expected sell price.
- The Greedy Farmer does not use Stop Loss orders