Building An Asset Base Part 4 - On Risk 1 comments

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How is one able to build his asset base quickly? I have talked about consumption habits, using compounding, using leverage. But ultimately, the key ingredient to building wealth has to be the ability to take risk and to recognise it.

The key tenet of valuation theory is that expected return of an investment varies directly with its risk, and common sense tells us the same thing: to get great rewards one has to put more bets on the line. What is the point of having a million dollars if one is going to put it in the bank and earn a measly riskless 2-3% annual return? Add the phenomenon of compounding and the mistake of underutilising the value of risk is multiplied over the long-term.

Put another way, it is getting risk to do work for oneself, to get above-market returns. It helps if one is young, because a long investment horizon facilitates higher-risk investments. But my experience is that increased knowledge can somehow dilute risk-taking appetite too. I have talked about this in a previous article ("Is too much knowledge a good thing?"). Risk appetite is a function of many factors including lifestyle and financial constraints, but more often than not it is diluted by over-analysis, a tendency that develops over time as one gains more experience/knowledge. Obviously I am not saying that more knowledge/experience makes one worse, but one has to be aware of how it affects one's decision-making and risk-taking.

Because, think about it this way: why should there be sellers in a stock if it is so good? Buyers seek reward, sellers seek to exit and cut holding risk; the price trades at the margin. If one over-analyses and tries to cut risk out of the investment, he is merely seeking to avoid the uncertainty that is the lifeblood of speculation and potentially massive market revaluation should the uncertainty resolve itself one way or another in the future. There are so many factors in a stock that can affect its price: fundamentals, liquidity, ownership structure, sector rotation, market, technicals, sentiment. One simply has to come to grips with uncertainty and seek not to avoid it, but to embrace and live with it.

One of my friends is an experienced professional in the financial sector and when I asked him in early 2005 what was a good stock to buy, he said "Food Junction". Why, I asked, and he said it was a defensive stock with good solid cashflow through good times and bad. Well true enough it was, but in early 2005 we have just had 1.5 years of recovery from the 2001-03 doldrums and was it risky to gun for more "uncertain" stocks? It was certainly not a time to be defensive, put it that way (of course, some will say I'm operating with 20/20 hindsight). Or how about ST Engineering, that favourite stock of The Capital Group that is universally acknowledged as the ultimate defensive stock in all senses of the word (and one would therefore guess this redeeming quality is priced into the stock as well) that has hardly managed to grow more than 10% per year over the last few years? In a bid to minimise risk and ensure regular dividends, the holder would have sustained tremendous opportunity costs. These are but two of the "safe" stocks that have underperformed the last few years; there are many more.

As indeed, there are many risky stocks that have caused the buyers anguish. That is the other facet of risk management that has to be emphasised: recognising the inherent downside risks in an investment. This is not mutually exclusive with my earlier point on developing an appetite for risk: my point is, one must recognise the potential risks in an investment, but NOT let it paralyse one into inaction or into taking "safe" investments.

Buying on the excitement of potential upside return without recognising the downside risk is seen to be the most common mistake of new investors/traders. For it is a simple mistake to make: psychologically, one will be optimistic about his new buy (otherwise why buy, he asks?), and tends not to subject himself to the self-doubt that might arise from a proper recognition of the inherent risks involved. And yet, not to do so is basically not giving respect for the opinions of the sellers, for why would they sell if not because they were relatively pessimistic (on the average)? Not recognising the risks of the investment also means one will probably have no exit strategy, because if he doesn't have a feel for where potential problems might arise for the business, then he won't be able to monitor these risks and catch them at the bud. The best way of managing such risks is typically to provide a margin of safety in one's investment selections.

The basic idea, after all the gobbledygook, is not only to see the risks for what they are, but also then seek to manage them and not let them manage you. Diversification, for all the offhand dismissals by the gurus, has some place in risk management, but the key is to understand exactly what type of risk one is trying to manage ("The case for diversification"). The other thing is to recognise that opportunity cost is often the most insidious risk that can creep into a non-performing "safe" portfolio; manage that risk by taking risk!