Take Stock – The Two Sides of Every Investment Decision

You can’t make a clear investment decision without considering this critical relationship.

The Motley Fool

Take Stock is the Motley Fool Canada’s free investing newsletter.  To have future editions delivered directly to you, simply click here now

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.

P.S.S. Be sure to follow us on Twitter and Facebook for the latest in Foolish investing.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

More on Investing

FREIGHT TRAIN
Investing

CNR Stock: Should You Buy Today?

Canadian National Railway has been hit in recent quarters, as economic growth has slowed, with CNR stock declining 10% in…

Read more »

Family relationship with bond and care
Dividend Stocks

TFSA Investors: 3 Cheap Canadian Stocks for Retirees

These three Canadian stocks are super cheap for retirees looking for a great buy that will last the test of…

Read more »

calculate and analyze stock
Dividend Stocks

CPP Disability Benefits: Here’s How Much You Could Get

Not everybody can get CPP disability benefits. If you want some passive income, consider investing in Royal Bank of Canada…

Read more »

growing plant shoots on stacked coins
Dividend Stocks

Boosting Your Monthly Income: TSX Stocks That Deliver

Dividend investing can boost regular or active incomes, especially select TSX stocks that pay monthly dividends.

Read more »

consider the options
Tech Stocks

Better Buy (2024 Edition): Shopify or Nvidia Stock?

Shopify (TSX:SHOP) isn't the only red-hot tech stock in town that could add to recent gains.

Read more »

Bad apple with good apples
Investing

5 Stocks You Can Confidently Invest $500 in Right Now

These stocks could significantly grow your investment over the next decade.

Read more »

Illustration of bull and bear
Tech Stocks

A Bull Market Is Coming: 3 Growth Stocks That Could Thrive

Given their high growth prospects and cheaper valuation, these three growth stocks would be an excellent buy as the market…

Read more »

Golden crown on a red velvet background
Energy Stocks

Enbridge Stock: This Dividend Aristocrat Could Gain in 2024

Enbridge (TSX:ENB) stock is looking like a great buy as management expects it to grow in 2024.

Read more »