Risk Series Part 2: Recognizing Risk

Risk Series Part 2: Recognizing Risk

Here it is! Part 2! By know we understand risk and why it is so important to pay attention to it. We know now that returns is only half of the equation. If we truly want to be great investors we need to take risk into account in everything we do. But that is only part 1, we understand risk now its time to be able to recognize it. Its great to know what something is but we have to be able to see risk to be able to take it into account and if you don’t know where to look for it then how can you take it into account with your investing decisions? You can’t.

I introduce you to the part 2 topic of our three-part risk series; recognizing risk. Like a snake risk can hide right in front of you but if you don’t know where to look you will never be able to see it. In fact, it hides in the most obvious places. Great investing comes down to being able to do two things: generating returns and controlling risk. Recognizing risk is the predecessor of controlling risk (Hint: that is part 3).

After going through the chapter of the book that generated the idea for this series by Howard Marks (Affiliate Link) I noticed three main places in which risk resides; high prices, market euphoria, and in reality. Like I said before it hides right in front of you. Below I will go into detail about each of these in the attempt to open your eyes.

High Prices

The first place is probably the most obvious. The risk for loss is much greater when you pay a higher price for something. If you need an example here, you go. You paid $25 for 1 share and I paid $50 a share for the same company. If it goes to $0, who lost more money? The more skin in the game you have the greater the risk.

High prices are a major way to spot risk but we are often told, and I have to agree with people who say, its almost impossible to time the market. That is true, trying to spot bottoms or tops is the game people have been playing for decades and no one has been able to do it consistently. If someone tells you they can, don’t believe them.

The thing I try to focus on and I think you should also is maintaining a major margin of safety on every investment. Having this margin comes from low prices. The difference between intrinsic value and price is the margin of safety. The lower the price, the larger the margin of safety. I am not telling you to try to time the market, I just want you to make sure you maintain a large margin of safety when making your investments.

If you are looking at a company a good way to get a feel for price is looking at the 52 week high and lows. It is not often that you will see a company continue to climb year after year leaving the 52 week high of last year being the low of the current year. If a company sparks your interest go see the price movement for the current year, if it pushing new highs that usually is not the best time to buy it. I would wait for a short term panic to push the price lower then jump in. ONLY IF THE PRICE IS WELL BELOW INTRINSIC VALUE. (If you need help calculating intrinsic value go check out my post about how I find companies and criteria I look for. It will help you get started).

Price is a good way to tell if a company is overvalued but there are other ways also. Price is all relative to the underlying business. Again, investing is owning part of a company so when valuing a company means investigating the company. If you use ratios like price to earnings (P/E) or price to book (P/B) you can get a feel if the company is over priced. I would look at the company then compare those ratios to those of the competitors to see if it is somewhat of a bargain. A P/E under 15 is “considered” undervalued by that metric and a P/B under 1 is “considered” undervalued also. Don’t solely rely on a single metric for your investing decisions. There is no tall tale sign of a undervalued company trust me. Finding undervalued companies comes assessing many different things.

Risk is correlated directly to one thing; the price you pay. The best way to reduce risk is to pay less. It is that simple, but I know it is much easier said than done. It takes a person of great patience to wait for their fat pitch. That is why many people fail at investing, it is because they do not have the patience. There is no company out there that is worth paying a massive premium for. If you do, then it is not an investment, it is a speculation.

Sound investing is done by purchasing assets well below intrinsic value and that comes directly from price. Risk hides in price and it can easily be forgotten. Do not let it be forgotten, price is all relative to the underlying assets. If you are unable to get a good price on your investment just save yourself the time and money; just walk away. Wait for your fat pitch and it will only help you. Warren Buffett has said many times before he makes more money sitting on his butt than constantly buying and selling companies.

Market Euphoria

The second thing you should look out for is market euphoria. This come when everyone seems to think it can never go down. At this point, investors are only paying attention to returns and neglecting to look at the risk they are taking on to achieve those returns. There are few examples of people who actually have picked the right small cap stocks to make a ton of money. They might be able to get 2/20 but no one is ever perfect. Another sign of market euphoria is many will mistake actual intelligent investing with a bull market. There are plenty of companies that will see a price increase for no other reason than they are in a nice bull market.

We know intelligent investing takes 2 things into account when you invest into a company, the potential returns and the risk taken on to make this investment. During a time of market euphoria the former is the focus and the latter is pushed to the side. Everyone is willing to do anything and everything in order to make some money.

During market euphoria you will see many things change; the main driver, however, is the change in investor behavior. At the end of the day the market is driven on investor behaviors, when they become irrational it can reflect so. An irrational market will price absolute worthless things at high prices. Why? The ripple effect.

Just like throwing a rock is a still lake, it only takes one person to encourage a few friends that the way to make money in the market today is to take on more risk. I mentioned this in part 1 but I think it should be repeated here also; risky plays have a lot of risk for a reason. If they did not they would not be considered risky investments!

Yes, during a bull market and sometimes you might be able to pick a small company that soars but those entitle a massive amount of risk. Once one person is able to encourage a few friend the process continues and then thousands of people are investing…no.. betting on financial assets they have no clue about.

As an INVESTOR, it irritates me that someone can own something and know nothing about it. That is what happens during a bull market. Few people actually understand what they own. It’s great during a nice bull market but they will only see how risky the investment was once the good times come to an end. During market euphoria everyone believes there is virtually no risk. Sadly, that is the farthest thing from the truth.

When an investor is willing to pay any price for any asset it can turn from a bull market to bubble quickly. There are 3 stages for a market. The innovators, the imitators, and the losers. You can make money a rational investment in the first two stages. The last one is where you get burned. Peter Lynch liked to refer to investments as baseball. You can invest in a company in after the 3rd inning and still make money. However, jumping in at 9th inning could provide you with little to no return.

The financial crisis of 07-09’ was caused by many things. One of the major factors though was the massive change in investor behavior. There was a common conclusion made by many that if you bought any company you could count on it to make you money. They were buying company and financial instruments that were so confusing even they could not understand them. Then once one domino fell, they all followed giving us the worst financial crisis since the great depression. There was many things you could blame on this greed and irrationality are the two that are at the top of the list. Promise me in your entire life that you will never buy any assets that you do not understand that alone is the biggest tragedy of all.

The last and final sign of market euphoria is when you yourself become sucked into the market euphoric state. If you are going through your due diligence and have found yourself a company that looks like a great target for a buy and then you say to yourself this can never go down you have just committed one of the greatest investing sins of all time. Don’t worry we all do it, the difference maker is if you act upon it.

If you fully invest in a company and truly believe there is never a point where the price of the stock can go down, you are in for a world of hurt. It can and probably will. If on the other hand you catch yourself and say, “this is a great company and even though it’s great there is still a chance the price might depreciate simply because that is how the market works.”. That is why they we have highs and lows, what goes up must come down and vice versa.

Before you buy that company accept the fate that the possibility of a drop in price is larger than you think but its okay, long term investors do not give short term market moves a great thought. They allow them to happen and can capitalize on them.

Market euphoria is another great hider of risk. It is essential for you to be able to identify times like this to recognize the risk that comes along with it.

There will be times when humans get way too optimistic of the future and this can lead to inflated markets with sky high multiples and plenty of people willing to take the jump in. It is easy to be an investor during the good times but to remain an investor during the bad times is when you have to summon the big investing bones to stay strong in your investments. Warren Buffett can sum up great investing in one quote:

“Be greedy when others are fearful and fearful when other are greedy.”

If you can follow these simple terms it will provide you with great returns along with lower risk. When everyone thinks the stock market is risky is the best time to be an investor.

Reality

The last place is where many of you will least expect it. The prior two points involved seeing risk and recognizing it in the behavior of others. This is a little different. For this one you have to be able to recognize risk in your own behavior. It’s not easy to do and can be a real ego buster for many of us, including me, so don’t feel alone. The risk that runs in reality is one that we have the most trouble seeing and can be the hardest to overcome during an investors career.

The reality of investing is that you have two options, you can passively invest and do fairly well for yourself. If you select this route it is much easier, less time consuming, and can provide great returns over the course of a long period of time.

The other option is you decide to invest in individual companies and try to find the big ones. These are the ones that can make you millionaires. The problem with this is it requires a ton of more time, it is extremely hard to do, and if you don’t get it right can lead you down the path to a bunch of losses. No one can be a successful individual investor if they do not have the time or desire to put in the work. The reality is that a lot of people just don’t have the time or energy to put into selecting individual investments. That is perfectly fine, let me tell you that choosing the first path is not defeat. In fact, it is probably smarter for the majority of everyone.

With that being said many will still choose to pick individual companies for themselves, like me. So this is where I am going to teach you to look within to find the risk.

We all have the inner senese that we are better than other people. Its egotistical but we all have it in us. Its human nature. When it comes to picking stocks everyone seems to think they posses the near impossible power to pick stocks and make millions. Even though the statistics are stacked against them, and I mean every number, they still think they can do better than everyone.

Now, there will be those occasions that happen to prove to be an exception to the rule but the majority of us, are like everyone else, and we have no magic stock picking ability. The biggest risk an investor can make is to think they are right and there is no way they will be wrong. When you’re looking at a company and you know its risky, but then you come up with logical reasons why it will go to the moon but you don’t think of any reasons why it could fail you’re doing yourself a great disadvantage. There will be money lost. I know this because I have done it. Everyone has losing investments, but to succeed in the market over the long term you need to have more right than wrong. Yes, your winners will carry your losers but if you can stop making loser picks for dumb reasons that will better your chances.

I learned quickly that the market is a beast and can play mind tricks with you. The business you think is going the moon probably is not and we all need to realize that. Individual investors need to take an oath for themselves that states they will not purchase a company thinking it is a sure bet, there is no such thing as a sure bet in the market. No argument. When you’re able to recognize riskiness in your own behavior you are bettering your odds of not picking a losing investment.

The Crowd

Okay, those were the top 3 places in which I thought you had to pay attention to in order to recognize risk which can be very hard. This one however, is more of a broad recognition. The crowd is your best friend. You want to stay away from where they go because more than usually they end up in places of very high risk without even knowing it.

You are probably thinking, how does this happen? Well like I stated earlier, everyone thinks they have the ability to avoid big losers. People tend to overestimate their ability to estimate risk and underestimate what it takes to truly avoid the harm it entails. People will unknowingly accept risk and when this happens over and over again the risk begins to grow into an amount that can be catastrophic.  For this reason alone I advocate a massive amount of research for each investment. By doing large research you greatly reduce the risk that might not be seen by the naked eye.

When you are looking at investing in companies, the worst place you can go is with the crowd. Hot stocks are great when the crowd loves them. It will push prices through the roof. The problem with this is the majority of people have very little knowledge of what they own and for that reason they can create the most riskiness asset of all. The market is shaped by the behavior of investors. When their confidence increases they are much more willing to take on riskier assets, but with a gain in confidence it creates much more problems. They will not see this, hence them being the crowd.

The crowd is commonly wrong about 2 things: the amount of return they will get and the amount of risk entailed in an assets.

“I’m firmly convinced that investment risk resides where it is least perceived and vice versa.”- Howard Marks

This is why the crowd is your best friend, they are usually wrong. When you are willing to be against them, it can yield great results. When they don’t like a company they will beat the price point down to a place where the potential return is greatest. When everyone hates a company, it might not be a bad thing to take a stance against it.

In Closing

In closing I leave you with this:

“High quality assets can be risky and low quality assets can be safe. It is just a matter of price paid for them…” – Howard Marks

If you know where to look risk can be recognized. Now, we can all see where risk resides. It is your job to make sure you see the risk and look for it in investments. No one in the entire investing universe is guaranteed a return. Sometimes people think they are entitled to it, that is not the case. Remember to look for risk when you are about to invest in a company and it will help you avoid some losses.

Peace and Love,
Michael

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