Your Reading List

Risk –How Much Can You Take?

The point of investing is not to have fun, it is to make money in a responsible way. Investors have a vast choice of ways to make it, yet few really estimate the risks they take with sufficient accuracy to avoid major losses from time to time. There are investment vehicles out there that are really akin to playing at the casino — there is most certainly opportunity to win big, but usually only the house comes out on top.

Let’s look at two of the bizarre investments that have come and gone from the market in the last 30 years: PIK bonds and dot com stocks.

PIK (pay in kind) bonds were to the bond world what stocks with no dividends were and are to the equity world. The PIKs could one day pay cash, but none to my knowledge migrated to investment-grade status. So buyers of these things paid good money for low-grade bonds that eventually paid even more low-grade paper. In the end, most of these things did not even have a proper secondary market in which to unload them. You could trade over the counter if you found a buyer or your broker did, but the terms were usually awful. Virtually every private investor who bought these things lost his or her shirt.

Dot com stocks that had no dividends, no earnings, no cash flow and even in some cases no business plan are the other real investment dog. In 1999 they were all the rage. The market for dot coms crashed in 2000 taking down everyone who played in this sandbox. While it lasted, dot coms were prized for burning up capital on the theory that spending would eventually lead to cash flow and profits.

What each of these bad investments had in common was an absence of periodic payments of income in the form of bond interest or dividends. Dividends, however, comprise 80 per cent of stock returns and their counterpart, bond interest, constitutes 100 per cent of bond returns of bonds bought at full price at issue. To ignore period payments of recurring income is not brave, it is downright foolish.

Steady income in the form of periodic payments has other advantages. It means that even if you overpay for a stock or bond, the cash flow will eventually bail you out. It also means that you are not dependent on the market’s moods. You can ignore the ups and downs and collect your dividends. Example: from 1987 to 1997, Royal Bank common was trading around below $10. Today it pays a $2 annual dividend on a $53 stock price. Had you bought shares at, say, $10 and not watched them rise and fall with the market, you would still have a $2 dividend, 20 per cent of the purchase price. The dividend is what counts, for the stock’s future remains captive of the market.

THE HUMAN ELEMENT OF MARKETS

Being hostage to the mania of the stock market is fine if you can buy when the market is depressed and sell when it is manic. That is harder than it looks, for moods are infectious. But if we look at the risks embedded in those moods, we can learn a lot.

Unlike natural phenomena like pea pod sizes, where nature rules and mass psychology is irrelevant, financial markets are deeply infected with human tampering and emotion. The tampering includes adding fees on to the prices of stocks and mutual funds, so that the returns are less than they would be were there no fees. As well, most markets have the characteristic that if you are long a stock or bond or other asset, the most you can lose if 100 per cent of your investment. But the upside, even if hard to attain, is theoretically unlimited.

The two factors — fees and lack of symmetry in returns, means that the distribution of returns in capital markets is skewed downward with a long, thin tail of gains for a few very lucky or skilled players.

Statistically, it means that the median return is toward the losing side. And that means that the investor who controls his risks and buys protection in the form of recurring income will tend to do better than the one who speculates on getting a big score just through capital gains.

WEIGHING RISKS

What I am telling you is already built into the market. What you read in the newspaper or on a web-site is in the price of a stock or bond by the time you are ready to trade. So information has little value or perhaps negative value by the time you get it.

What to do? The distinguished mathematician, philosopher and market trader Nassim Nicholas Taleb, author ofThe Black Swan andFooled by Randomness,has said that what we don’t know is more important than what we do know.

Think about that for a moment. One reason that stocks gyrate so wildly is that news about them comes as shocks to investors. Had they given weight to risks not reflected on bank balance sheets in, say, 2007, they (and I too, I will admit) could have sold bank shares in January, 2008, bought the shares back in early March, 2009, and made a fabulous return.

Today, with gold booming and trading as I write this column at US$1,337 per ounce, investors are torn between the idea that it is in a bubble and that it will go to US$1,800 within a year. Or more — just pick your oracle.

I have no idea what will happen. But I do know that gold pays no periodic income. That makes it a casino play. You could win if the stuff rises, but your odds are not much different than those in penny flipping or roulette. Owning a gold mine with a dividend reduces bullion price risk but adds a measure of industrial risk. It is worth considering, however.

If you buy a gold participation note from a bank, usually in the form of a GIC that pays nothing if gold does not rise by a given amount and, for any defined gains, you get only 25 per cent of the rise, you are shortchanging yourself — accepting a high management fee for a reduced return. So the best advice on gold is this — buy some if it appeals to your sense of insurance against debasement of currencies or for other reasons, but don’t buy more than you can afford to lose. The gold market is a casino. And it does not treat players any better than other casinos.

Bottom line: never forget that capital markets don’t have nice bell curve distributions of returns. The normal bell curve does not work in stocks and bonds and even less so in mutual funds with high fees. You can expect to participate in the normal range of returns if you make average investments in major companies or buy low fee exchange traded funds that replicate the TSX or the large cap TSX 60. The more recurring income you buy, the better your odds of beating the casino.

If you buy investment grade bonds at or less than the redemption price, you lower your risk of cash loss, though you may risk asset erosion by inflation that may one day run at a rate higher than current bond interest. If you buy common stocks with good dividends of, say, 2.5 per cent per year or more, your odds of coming out a winner with an annual return of 6 per cent to 7 per cent on your investment are improved. That’s the historic average of common stocks with attendant volatility. Bond returns are 2 per cent to 4 per cent or so with less volatility and less inflation protection.

AndrewAllentuck’slatestbook,WhenCanI Retire?PlanningYourFinancialLifeAfterWork, waspublishedin2009byVikingCanada.

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

Comments

explore

Stories from our other publications