Sunday, December 23, 2018

Risk Management - much to do about nothing!

Around this time of the year, I do a lot of navel gazing. Projects are coming to an end and I ask myself “What I am going to do next”. What do I feel is worthwhile doing or should I cool it and stabilize my holdings? Do I want more rental properties and manage my tenants, or do I prefer a more hands-off approach? Whatever I decide, the number one consideration is: accumulate more assets so I can do more and do it longer. Because when you own assets, you have numerous options as what to do with them!  
A very important question every investor will have to define for him or herself is: “What is risk and how do I deal with it?”.  Risk is in the eye of the beholder.  Some investors consider stock market volatility a risk and they tend to sell at the first sign of trouble. Unfortunately, when they are ‘out of the market’ they are missing out on 40 to 50% of the profits from stock market investing, namely dividends.  Thus, this style of investing typically leads to underperformance no matter how perfect one times the market extremes. Nobody times the market perfectly all of the time. Also, transaction costs such as commissions and taxes that must be paid, these days referred to as ‘transaction friction’, will reduce your returns.  
The real risk when moving in and out of the market is that you sell at maximum ‘pain’ when the markets bottom and the loss of that forced sale is permanent. Because you bought high and sold low!  Then when the market recovers you miss out on the resulting ‘profits’ because you are in cash. It is better to run through the entire cycle, collect dividends and use excess cash to add during the times when valuations are low.
The key though is that volatility is not risk but opportunity to buy cheap and sell high. Volatility is only risky if you sell because your own investor pain is too large or you have too little cash flow and you are ‘forced’ to sell. Permanent loss, that is what risk is really about.

Risk is about losing money permanently! Unrecoverable losses are real losses. If you invest in an asset that becomes worthless and no longer exists, that is a real loss. Your home may fluctuate but you only lose or win when you sell!  The purchase price is important, but much more important is how the value of your asset appreciates and how much cash it produces over the years. Even if you bought something 10 or 20% below its regular asset value how much does that add to your profits over the next 10 or 15 years? Very little. Half your profits are from cashflow (rent or interest or dividends) and less is from appreciation. How much did that initial saving really ad to your return? Good quality assets may fall very little because investors are allways on the look out for bargains.

Cyclical investments are different because of their extreme volatility and the duration of holding these investments is often less than 4 or 5 years. Also, the pricing is so crazy that what this year trades at a peak, next year is down 90%. Cyclical investments are speculative and so you have to think differently about them. Having said that, if you invest in, say an oil company and you must wait 7 years before you double your money, your annual return is still only 10%!  What are you going to do if you time it very well and you are only 3 years from trough to peak in a commodity deal?  If you are in cash for the remainder of the cycle, i.e. 4 years, your annual return over those 7 years is still only 10%. You must still invest that money for at least 4 years elsewhere where you get similar returns, or you must accept lower long-term returns than the flashy headline profit of a double!

Risk is not volatility because many investments have a long-term median return and that is what really counts. Risk is when you make a permanent loss. So that is why preservation of capital is an important topic. But again, don’t only look at your net worth today and compare it to a peak you made recently or even a year ago. Look at it over 5 or 10 or even better 20 years. Sometimes stocks are good investments other times it is real estate or your career.  Net worth is just like the stock market a volatile matter that, hopefully increases over time. It is just a matter of how much volatility you can stomach in individual investments or in an investment class or in your net worth! 

If you learn to think this way, investment risk is typically very low, and chances are that your net worth has increased substantially 5 to 7 years from now. Why do I say 7 years? Simple if you make on average 10% (which is a discount rate many business and investors use) then you double your money in about 7 years; that is the rule of 72! (If you don’t know this rule then as a priority, google or bing it!)

Do yourself a favor, when you track your net worth and you reach a new high, first congratulate yourself. BUT you should realize that it is about a trend and that without anyone’s fault you maybe ‘down 10 or 15% ‘, just because of how the various markets value your assets. Now, if somebody knocks tomorrow on the door of your home and says to you: “Here is $10 for your house”, do you reply: “Oh now my house is only worth $10”? Or, do you shut the door in the face of the bidder, “Mr. Market”, and say: “No way Jose!”  So, just because the market offers you a certain value for your assets, that doesn’t mean that that is your true and only net worth!  Even five minutes later, someone else may knock and offers you $100,000. Do you then say: “My rate of return over the last five minutes was: 1,000,000,000% per annum”?  The same is the story for all your assets!  It is the long-term trend that counts, not daily nor other temporary market fluctuations. Here is another way of looking at it:  Your net worth is $100,000 and your neighbor’s is $50,000. The market falls 10% and you are now $90,000 and your neighbour is $45,000.  Who got richer? The only guy who didn’t lose anything is the one who owned zero! During tough times we all have a lower net worth; the key is how you react! For most investors doing nothing is the best answer: Benign Neglect.

I wish you will accumulate many assets in 2019

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