Use Diversification to Reduce Your Investing Risk


 

 

 

 

 

 

 

 

 

 

 

jerichopool

Let’s say that you’re playing a game where you bet $10 on the toss of a coin.  If it is a fair coin – equally weighted on both sides – you’ll guess right half of the time and wrong half of the time if you play for many runs, say 100 or more.  Sometimes you might go on some streaks where you guess right five or even ten times in a row.  Have one of these, and you may begin to think you can make money at this game.  But you’ll also have streaks where you guess wrong several times in a row.  You might chalk this up to “bad luck,” and return later to play some more to “get even,” or you may decide this is not the game for you.  Over long periods of time, you’ll come out about even.  If you are charged a small fee for each toss – say $1 per throw – you’ll slowly lose all of your money.  This is how the house always wins at casino games like baccarat.

If you were to buy a single stock at the start of each day and then sell it at the end, you’d be in the same position.  Even if you try to time your trades and limit your losses, as they do in day trading, you’ll find over long periods of time you’ll come out about even on your trades since your chances of buying a stock that goes up soon after is about the same as your chance of picking a stock that goes down soon after.  You’ll be losing money, however, because you’ll be paying out money in trading fees.  When you’re wrong and take a loss, you’ll still pay out fees.  When your right, you’ll pay out fees and even pay out taxes if you come out ahead in a given year.  Some people might hit a lucky streak on some days or even for a few weeks, but eventually the odds will catch up with them.

But what if we change our coin game.  What if you still lose $10 when you’re wrong, but you gain $20 when you’re right?  You would still be wrong about half of the time, and you’d lose money when you were wrong.  You might even have a losing streak and lose $30 or $40 fairly quickly.  But if you kept playing, or alternatively, if you threw several coins at once, you would come out ahead because you would gain more when you were right than you would lose when you were wrong. 

If you played a lot of times, it would be fairly easy to predict what your gains would be.  If you just played five times,  you could be up $100, but you could also be down $50.  It is just the luck of the draw.  If you played 100 times, however, you would probably be up between maybe $400 and $600.  If you played a thousand times, you would probably be up between $4500 and $5500.

And this leads us to the next tactic given in  Risk Allows You to Make Money in the Stock Market to deal with the risk associated with buying stocks:

2.  You diversify your investments to reduce single-investment risk.

As stated in that post, stocks are priced such to justify the risk that you are taking.  If they make the earnings that are predicted and pay out a dividend (or increase in price due to a predicted future dividend), it will provide a big enough return to justify the risk that you were taking.  Because you’re taking more of a risk than you would be by putting your money in a bank account, you get a bigger reward – on the order of 12% per year on average (if invested for many years).

The issue is, however, that while the stock market may make those kinds of returns, there is nothing to say that you will make that kind of return no matter which stock you pick.  You could buy stock in a company that makes bad business decisions, has corruption in the board, or simply is in a fading industry (think buggy whips).  In that case your stock would just sit there or even decline in price.

To deal with that risk, you do the same thing that you do with the coin game – you play a lot of times.  If you buy a set of stocks, there will be a few that won’t work out (I’d say something like 1 in 20 of the stocks I buy collapses in price if I hold long enough), but the others will make up for the loss and then some.  Just as you can make $20 when you’re right in the coin game and only lose $10 when you’re wrong, when you buy a stock the worst you can do is lose 100%, but you can make 200%, 500%, or even 1000% gains.  You just need to buy enough different stocks  to ensure you’ll have some gainers along with the losers.

One of the easiest ways to gain diversification is to buy mutual funds since they invest in many stocks at a time.  You can just buy one fund and invest in 20, 50, or 100 companies or more.  Buy funds that invest in different segments of the market, like a large cap fund and a small cap fund, and you diversify even more.  This is really the only way to invest your retirement savings because you can’t afford to be wrong.

With other investing, such as your savings to become financially independent, you can choose to concentrate holdings and perhaps take on a little more risk in order to try to beat the markets.  Here you’re trying to pick the next Microsoft or Home Depot that will provide huge gains over a number of years.  Even in this case, however, you need to diversify out into more than just a few companies.  Perhaps buy the best stock in five sectors to start, then diversify out into ten or twenty as your portfolio gets larger.  That way if things happen that are beyond what you can predict from reading the yearly reports, you’ll have other positions to fall back on.  As I always say, never have more in a single stock that you can afford to lose.

Got and investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Use Time to Reduce Your Risk


 

 

jerichopoolIn Risk Allows You to Make Money in the Stock Market, I talked about how taking risks is what allows you to make more money investing in stocks than you could earn from a bank account.  Because you are putting your money at risk, the price you pay for shares of a stock are reduced (or discounted in accountant speak) from the price they would be at if you were assured that the company would make the earnings expected and pay those earnings out in a dividend.  You might get a check for $100 per year for your $1000 investment, or a 10% return, but you might not.  You would therefore invest only $500 and still expect a $100 per year payment if the business does well and things work out.  You get a higher return (20% instead of 10%) to make it worth taking the risk.

Luckily, with the market-based system you don’t need to figure out the right price to pay to get an appropriate risk premium.  Smart people with sophisticated computer programs do that for you by buying shares if they are cheap and selling shares if they are expensive.  As a result, the price of a stock will generally, but not always, already contain an appropriate discount for the amount of risk you are taking.  To improve your chances of getting a good price, you can also follow the share prices for a few weeks before you make a purchase and try to buy when the stock is it the low end of the range.  This can be done easily by placing a limit order, where you set the maximum price you are willing to pay for a stock.  You can also look at the price-earnings ratio, or PE, or the price to sales ratio, or PS, and only buy stocks that are at or below their average PE or PS level, averaged over the last several years.  In general, because I am buying for the long-term, I don’t worry too much about getting an extra ten cents or quarter per share since it won’t really matter in the long run and I may miss out on a big move up if I’m too picky.  Instead I tend to pick stocks from my watch list that have declined in price recently by at least a few dollars when I have money to invest and am ready to buy more shares.

 In Risk Allows You to Make Money the Stock Market I gave three ways to help manage risk and put the odds on your side.  These were:

1.  You invest appropriately for the time frame you have.

2.  You diversify your investments to reduce single-investment risk.

3.  You choose your investments appropriately based on your time frame and objectives.

Today I’ll cover the first item, investing based on your time frame.

The more volatile the investment you’re making is, the less able you are able to predict future values.  If I put $1000 in the bank in a CD paying 5% per year, I can predict with almost certainty that I will have $1050 in a year.  If I put $1000 in a stock that I think has the potential to grow earnings by about 15% per year, I have no clue what the price of the stock will be in a year.  I might have $2000.  I might have $500.  All that I know for sure is that I’ll lose $50 or so immediately due to transaction costs and brokerage fees.

The company I invest in may have a bad quarter, miss earnings estimates, and fall 20%.  The economy in general may run in troubles and the stock price may fall.  A competitor in the same industry as the stock you purchased may run into trouble and people may sell stocks in the whole industry.    The company may even post record earnings, but those earnings may be less than the “whisper numbers” some people may be expecting, and the price of the stock may fall.

While it is hard to time when the price of a company may go up, it is reasonable to expect that the stock of companies that are run well and are growing will increase in price at a rate about equal to the growth rate of their earnings.  This will be in fits and starts, with some declines or even crashes along the way, but over long periods of time you should be able to get a fairly predictable rate of return.  It might be that the stock doubles the first year and then trades within a range over the next few years, it might be that the stock price increases steadily each year, or it might be that it goes nowhere for several years and then doubles in price.

The way to manage the risk that the stock price may not increase over short periods of time is to simply only buy stocks if you are planning to invest for a long period of time.  For mutual funds I’d be reluctant to invest unless I was planning to invest for at least five years and maybe ten years or longer.  For individual stocks I’d probably be looking at ten years or more.  This gives time for the company to grow and people to realize that it is a great company and bid up their stock price.  I don’t have to guess what will happen with the economy, people’s emotions, or understand what trading strategies people are employing will do to the price over any given period.  I just know that if I wait long enough, things should work out and I should get the return needed to justify the risk I am taking.

I therefore would use the following guidelines:

1.  For cash needed within six months, use a bank account.

2.  For cash needed in one to three years, invest in bank CDs or perhaps high quality bonds set to be redeemed within the period.

3.  For cash not needed for five to ten years, split the money between stocks, bonds, and cash, and use mutual funds to diversify.

4.  For cash not needed for a decade or more, invest in stocks through mutual funds and select individual stocks.

By using time to put the odds in your favor, you can get greater returns by collecting the risk premium.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Looking at Retail Stocks


 

 

farmhouseMy wife is looking to invest some money in her account, so I pulled out my watch list of stocks.  I normally keep a list of stocks that meet my criteria as good, long-term investments handy for just such a time as this.  I then down-select from that list based on 1)the relative price of the stock versus what I consider to be “fair value” based on future earnings potential and 2)how big a position I have in the stock already.

In looking through the list this time,  two retailers looked like good options.  These were Pier One, the ubiquitous chain of home decor items, and The Container Store, a relatively new chain of stores that sell containers to hold the knickknacks you pick up at Pier one but no longer want to have out taking up space on your end table.

I only had a few shares of Pier One in my son’s educational IRA account, so there was room for plenty more.  It had fallen from about $20 where we had bought in to the low teens.  This made an attractive entry point, although it makes you wonder if the chain has lost its luster and is no longer fashionable.  (Note that I consider all of our accounts when deciding whether we are too heavily invested in any one position.  There is no mine and yours when you become married.)

I had bought a fairly sizable position in The Container Store, but I was still building the position during pullbacks in price and it could stand to get a bit larger.  It had also fallen back a bit since I had bought in, although not as badly as Pier One.  The Container Store appears to have a lot of room for growth, but really doesn’t have quite enough history to know if they are going to grow into a retail behemoth or fail as a concept.  There is something attractive about getting in early, however.  Wouldn’t it have been great to get into Home Depot near the beginning when they only had stores on one or two states.

So what are the things about these two businesses that make them SmallIvy stocks?  Well, they have shown a good, consistent earnings growth rate.  I like stocks that are able to grow their earnings year after year.  I find that I tend to buy into retail and restaurants quite a bit because they are really designed for growth.  All they need to do for a period of time is open another store.

The second thing I like about them is they have a relatively high 3-5 year appreciation potential, as listed by the Value Line Investment Survey, the stock rating and screening publication I use.  I look for stocks that are have the potential to grow a large amount over the next several years.  If I can find stocks that have potential returns between 15 and 20% per year for the next several years,  I tend to examine them more closely.

The third thing that I like to see is a steady increase in price.  If I can find a stock that you could lay a ruler over and find an ever-increasing price curve, I’ll definitely take a second look.  That means that they have been able to deliver consistently good results over a long period of time.  A few stocks do that for decades, and those are the truly great ones.  In this case The Container Store doesn’t have a long enough history to say yet, and Pier One has seen a few ups and downs.  Of course, most stocks saw downs during 2008-2009 since people stopped spending since they could no longer use their homes as a piggy bank.

In the end I did what any smart investor would do – I left it up to my wife to decide.  She decided to go with Pier One.  We’ll also put some of the money in an ETF – probably the Vanguard Growth Fund ETF VUG.  No reason to put all of our eggs in one basket, particularly when it’s my wife’s money.  Luckily I’ve done fairly well in the past with her accounts with picks like Sealed Air (bubble wrap) and Equifax (bank transaction services).  Hopefully this pick will work out as well.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.