Ideas for Managing Investment Risk

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A friend of mine last week asked about buying some ETF’s. He knew I spent time buying stocks, but as he said, ” I don’t want anything exciting”. His view was buying ETF’s was less risky, and therefore better aligned with his investing goals and interests. I can’t argue with his thinking, but I am not sure it would suit my investing goals and interests. We are two different people.

Risk is often the specific factor that people will cite as to why they will not buy individual stocks but instead look for other avenues for saving and investing. The attraction of vehicles like ETF’s and mutual funds fulfill their need to be invested, but avoids them having to spend the time and worry of picking stocks. The diversification achieved through these vehicles creates the illusion of less risk, and in a steady market that is generally true.

I checked out iGoogle for a definition and it talks about risk as either a source of danger as well as the probability of a negative outcome. It also has two interesting examples that identify a risky investment or losing money. For the purposes specific to investing I would like to call it a measure that specifies the chance of an outcome not matching your expectations. If there is an 80% risk of rain bring an umbrella! If it is just 10% then you might be fine. The difference between investing and rain forecasts is you can have 0% chance of rain, but never 0% investment risk.

An investor gets paid for taking a risk with the general rule being, the more risk you take, the more money you make. The economy is based on this simple concept. If someone else uses your money they pay rent, or interest. The likelihood of you getting your money back determines how much interest you charge. This exact same concept applies to buying stock. If the risk is higher you expect, and demand a higher return for taking that risk.

Let’s start by examining a government Savings Bond. I did some poking around and found one that is paying a huge %0.65. That means a $100 bond held for 1 year pays you 65 cents. With government bonds there is almost no risk. You will absolutely get paid. This particular bond is also flexible. Part way through the year you can get your cash back. No interest, but, no problem either since you are not locked in. For a government bond you have not accepted much risk, so the money you are paid is tiny.

The better question to ask is “did you make money?” With an inflation rate at about 2% you need to make $2 on your hundred-dollar investment, just to stay even. In this case with only 65 cents you actually lost wealth since you can buy less with the money you took out after a year. You actually traded financial risk for inflation risk and lost.

Currency risk is an added factor to consider. Let’s consider an American that buys a Canadian Bond in February 2009 and now it is February 2011. You may be surprised to find you have a bonus gain on the exchange rate. In 2009 the Canadian dollar was trading at $0.80 cents against the American dollar. As of February 2011 they are close to parity. In 24 months you are up 20% due to the exchange rate. However, guess what happens to the Canadian buying an American bond. That is a 20% loss.

As a Canadian investor I was enjoying a subscription to an American investment newsletter a few years back and the authors were great. Every stock they highlighted went up at least 10%. Unfortunately because the Canadian dollar had gone up the value of my account had actually gone down. That was learning currently risk the hard-way.

Taking a look at the stock market, I started by using the stock filter at theglobeandmail.com and on the New York stock market I found 40 companies with a yield of 0.60%. Very close to the savings bond rate. I looked at Eldorado Gold with shares closing at $16.81 and an annual dividend of 10 cents per share. Over the last week this stock has been had a low of about $15.90 and a high of $17.00. If you bought it at the market low you would still be getting the 10 Cent dividends but you have only paid $15.90 per share. That is a slightly better yield of 0.629% so a few days can make a difference. For this stock the 52 Week high was $20.23. If you bought it then the yield was only 0.49%.

As I mentioned with the Savings Bond I used as an example you can get your cash out at any time. This is also true of a stock like Eldorado Gold, but, you may be at the market high of $20.23, or the 52-week market low of 11.39. As an example if you could buy partial shares, let’s say you bought $100 dollars of Eldorado at $16.81 for a holding of 5.949 shares of Eldorado and you sold them at the high of $20.23. That is a sell price of $120.34 or a 20% gain in addition to the 10-cent dividend per share. Clearly you are a genius in the markets. The bad news is you may have needed the money quickly and sold for the market low of $11.29. Now your $100 is only $67.16. Not good.

So the decision to make is, if you can see into the future, are you satisfied with the potential to make a 20% gain with the risk of a 35% loss. You need to follow some rules to limit your losses. Here are some of my best ideas.

1) Be faster to sell than to buy. Back to risk. If the outcome is not matching your expectation don’t be the last guy holding the bag.

2) Diversification. Do not to put all you eggs in one basket. Understand how to invest in different sectors, different types of investments, and for different time frames. But rule #1 still applies. Being diversified does not mean holding a lot of different losers.

3) Diversify your strategies. This includes how to pick stocks, working with options in a variety of ways and also learning about fundamental and technical analysis. You can also do a lot of reading on the difference between growth and income strategies.

4) Get advice. Along with get advice, also be aware of the source. Advice can come from a financial advisor a subscription newsletter or that well dressed guy on the elevator. Do you know their history of success? Are they getting paid for the advice they give you and does that payment affect the advice they give?

5) Have a Plan – Trade the plan. I prefer the notion that you buy a company to go on a journey of discovery. The discovery may be good news, or bad news, but if you know why you started, you will know when the trip is over. A trading plan mitigates risk because if the reason for the journey changes or the navigator gets lost, you can get out of the car.

Try this for yourself. Use the above rules and apply them to each position you currently hold. Why did you buy it and on who’s advice? How long has it been since you checked to see if the advice still applies? What was the purpose of the journey and has the company arrived there yet? For both the market sectors, and strategies you have used are you diversified? You now have a choice. If you don’t have the answers to these questions, then perhaps you should consider some savings bonds. Your portfolio is suffering the one other risk not discussed here – unknown risk. That type of risk is very hard to manage.

 

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