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Any time you take a chance you better be sure the rewards are worth the risk because they can put you away just as fast for a ten dollar heist as they can for a million dollar job.
— Johnny Clay (Sterling Hayden), discussing his planned robbery with his girlfriend (1956) in Stanley Kubrick's film The Killing. (Based on the Jim Thompson novel)
TORONTO (GlobeinvestorGOLD) — The excitement you feel when you're long a junior mining company that's just pulled a hot drill hole, or when a stock you're long shoots up on a hostile takeover bid — that's the frisson you can only get from risk. Or maybe, bungee jumping. Sure, it can be fun when things are going your way, but when bull turns bear, you can get clawed pretty badly.
Risk is what drives markets. Risk and return: the higher risk, the higher the return needs to be to compensate. Looking for what Peter Lynch called a "ten-bagger," that's the Johnny Clay school of investment philosophy. Weighing the risks, though, and finding enough ten-baggers to make up for all the strike outs, isn't so easy. Plus, you'll need Prozac.
No, risk and return may be linked, but the idea is to get the maximum return for the least amount of risk, not to maximize risk in the hopes of a big return. This may sound obvious, but try explaining it to the guys lined up to buy $100 each worth of Lottery tickets at your local Mac's Milk.
Now, how you go about calculating that optimal spot that maximizes returns at the least, or at least most tolerable, level of risk, is more than I can fit into this column. However, I direct the interested reader to Google the phrases "Modern Portfolio Theory," "Harry Markowitz," "Sharpe ratioPortfolio diversification," and "the efficient frontier" for more information.
When you first open an investment account with a dealer or advisor, just about the first thing he will ask you about is your tolerance for risk. It's the Prime Directive for investment advisors. The Know Your Client Rule is all about knowing your tolerance for risk. A lot of investors don't give it as much consideration as maybe they should.
There are all kinds of risk: market risk, interest rate risk, reinvestment risk, inflation risk, catastrophic risk, credit risk, country risk, currency risk, margin risk, and timing risk — to name a few. But generally, risk, for investment purposes, can be defined as the variability of returns, and the less variability, the better.
There's no point in being up 20 per cent one year if you're down 20 per cent the next. Yet, a lot of the people I meet when I'm out walking the dog, when they talk about their investing experiences, are doing exactly that.
I admit, I don't get it, but then, I happen to be particularly risk averse. That's partly a function of my age, and partly a function of having gone from being a paper millionaire before I was 30 to having negative net worth before I turned 31. But I have managed — by eschewing risk and following some simple rules — to come back from the dark side, and, while I'm not ready to retire yet, I'm getting there. So, rather than suggest some sporty kind of investment for you to take a flutter on, I'm going to share my risk-averse methodology with you.
My first rule is to never put more money into any stock than I am prepared to kiss goodbye. This is a rule I discovered back in my mining days, and while I used to think it pertained mostly to junior mining stocks, there's a whole lot of people who bought Nortel at $120 (and $90, and $45, and $5) who can attest to its universality. For me, this works out to no more than around 2 per cent of my total portfolio in any one stock. That way, if one suddenly goes Chernobyl on me, it isn't the end of the world.
There are many ways to minimize risk, but the main ones are diversification, investing for the long term, and avoiding trying to time the market.
Diversification is simple to understand — don't keep all your eggs in one basket. If you had invested your entire portfolio in Nortel at $120 a share, then you got severely hosed when the bubble burst. The idea is to have your portfolio spread around different sectors, different markets and different instruments, ideally ones that have little correlation with each other, so that when one sector is down another is up.
Investing for the long term reduces risk because over longer periods of time, the standard deviation of returns (a measure of variability) gets smaller.
Avoiding trying to time the market means always keeping some cash on hand — park it in a money market fund or in Treasury Bills or Bankers' Acceptances — for when stocks are cheap. It is also generally accepted that it is usually better to leg into a position over time rather than buy it all at once — the concept of dollar cost averaging, though I'm not particularly observant of this principle myself. I don't usually buy big enough size to have to worry too much about this one.
Apart from a handful of basic trading rules, and some quantitative techniques (you'll need a calculator), those three simple rules are the basis of portfolio management theory. It ain't rocket science, folks, though it takes a little discipline to follow.
Perhaps the best advice on the subject of risk comes from the Nobel economist Paul Samuelson (whose introductory economics textbook, the appropriately named "Economics," was the bane of many an undergrad for 50 years). He once said that "investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas." That's my investment philosophy in a nutshell.
Harry Koza is Senior Analyst in Canadian markets for Thomson Financial/IFR. At various times in his career, Mr. Koza has been a prospector, metallurgist, project manager, engineer, as well as an institutional bond salesman for 15 years. His current area of expertise is in high-yield distressed securities and corporate bonds in general.