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When most (all?) of us consider a stock, one of the first things that comes to mind is how much money we’re going to make. We’re focused on reward.
What we often overlook, or fail to question, is how much risk we’re taking on to achieve this projected reward.
Let’s stop doing this — together!
Considering risk, after all, drastically alters our required return from a specific investment.
In an interview with the Manual of Ideas, Howard Marks, one of the most respected investors of our time, said, “I think that the greatest accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk.”
By the end of this week’s letter, you’ll be on your way towards this accomplishment!
What risk isn’t
At the same Morningstar conference I referenced in last week’s letter, I heard some of the featured speakers miss the mark when it came to defining risk.
If you get nothing else out of this week’s letter, please leave with the following engrained on your brain:
VOLATILITY IS NOT RISK.
Say it with me: Volatility is not risk!
If anything, volatility means opportunity. For instance, up until yesterday, volatility had virtually disappeared, and if you’re anything like me, it’s been awfully tough finding attractively valued investment ideas.
Should volatility rise, some stocks are bound to get unjustly beat up, thus creating an opportunity to add them to our portfolios at a lower level.
One more time: Volatility is not risk!
Evaluating risk and reward
With that in mind (forevermore), risk can generally be thought of as the probability of taking a capital loss, and the severity of what that loss might be. The thing is though, risk can’t be viewed in isolation — it has to be considered alongside potential reward.
That’s why a statement like, “I don’t want to own that — it’s too risky” doesn’t hold water. Or at least, it isn’t complete. We should say “I don’t want to own that because the potential reward does not compensate me for the risks involved.”
As Marks’ quote indicates, you want to be sure that your probability of reward, and the size of that reward, is always greater than the potential risk.
To help ensure that you’re consistently tipping the risk/reward relationship in the right direction, here are three scenarios to be mindful of:
1. Buying into a bad business model: Risk > Reward
An ice cream stand at the North Pole. An NHL hockey team in the Arizona desert. A dedicated smartphone maker. These are bad business models that make it exceedingly difficult to extract a profit by investing in them. You are unlikely to be compensated for the risk that you take investing in a business model that has the cards stacked against it. There are too many good businesses out there to waste your time on the bad ones.
2. Leverage: Risk > Reward
This one is two-pronged, but the outcome is the same in both cases. Whether it’s your personal investing situation or tied to a company in which you’ve invested, leverage puts destiny into the hands of strangers.
From a personal standpoint, a margin call may force your hand and cause you to liquidate your portfolio at the very time you should be buying. And from an investment’s standpoint, if the company can’t stand on its own two feet without a continual dose of financial aid, it isn’t likely to be around for very long. Should its access to debt ever be cut off, as it was for so many in the financial crisis, it’s lights out. Investing in a highly levered entity isn’t worth it.
3. Cash: Risk < Reward
In this Fool’s opinion, it’s a good idea to always have some cash on hand in your portfolio. (If cash is good enough for Buffett, it’s good enough for me!) Yes, you’re earning nothing on that cash in today’s interest rate environment, and you lose a little when it comes to purchasing power if inflation is at work. That’s the risk. The reward, however, can be huge because cash gives you the ability to be opportunistic.
The Foolish Bottom Line
There are a lot of numbers tied to the world of investing, but nailing the risk/reward relationship is far more art than science. Numbers are just part of the game.
To put yourself on the path to successfully navigating this relationship, get in the habit of not only considering the potential upside of an investment (or any decision, for that matter!), but the downside as well. With time it will become second nature, and you’ll become a better investor because of it.
Fools Want to Know
Last week we had several submissions to our “Ask a Fool” service, which allows our fellow Fools to communicate directly with us and send along any burning questions they may have. We look forward to addressing these queries in a future Take Stock or in a dedicated Fool.ca post. Please, don’t hesitate to reach out with whatever’s on your mind.
The address is [email protected].
Recent Developments
You may a growing number of contributors on Fool.ca. Expect this trend to continue as we plan to steadily increase our coverage of the Canadian market.
‘Til next time … happy investing and Fool on!
Sincerely,
Iain Butler
Senior Analyst
The Motley Fool Canada
P.S. Attention all investment writers! We’re still looking for new contributors for Fool.ca, so if you’re interested in providing Foolish commentary on Canadian stocks, or if you’ll be in the Toronto area on July 11 and are interested in attending our Blogger Bonanza, send me an email by clicking here. We have a limited number of seats to fill.
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