03 Dec 2012 06:39
What is risk? The conventional definition of risk in finance literature is price volatility. But to super-investor Warren Buffett, risk is the permanent loss of capital.
Unless you need to cash out at very depressed market levels, or the investments or stocks/companies you own have no more capacity to recover, price volatility is just noise in the market, says Mr Buffett.
On the other side, what is return? Return to an investor is the income you get from your investment, as well as the rise in the price of the investment. Of course, you’d want to be able to get back at some point the entire sum of the capital you put in as well.
How does one get good return from an asset? Well, the more cheaply you can acquire a good asset, the higher your return will be. Your dividend yield is higher, your capital appreciation is higher.
Next question. When you get a good asset cheap, what are the chances of you suffering a permanent loss of your capital? Small. Hence, your risk is low.
So, to get good returns, does it mean we have to take high risks? Not necessarily!
It is very common for us to miscalculate the probabilities and act less than rationally because of our tendency to, among other things, prefer excitement over staidness, to want instant gratification instead of staying for the long haul, and to seek “safety” in numbers, that is, to just follow the crowd.
Take Apple. Given how well the stock has done, I’m sure most of us wish we had the stock in our portfolios, preferably from as early as 10 years ago. A sum of US$10,000 (S$12,200) invested in November 2002 in that “fruit company” – as Forrest Gump described it – would have grown to US$750,000 today.
But nobody could have predicted back then how well Apple would do. This is but one of the many trajectories that the company could have taken in the intervening 10 years. It could have gone the way of Nokia.
In expectation, as scholar and investment expert Nassim Taleb puts it, a dentist is considerably richer than the rock star, the hedge fund manager who made it with one big bet or the successful entrepreneur. “One cannot consider a profession without taking into account the average of the people who enter it, not the sample of those who have succeeded in it,” he says.
We talk about Apple today because it has succeeded. And that’s how typically a stock comes onto the radar of a novice retail investor. The stock is in the news because the company has had three or four years of good growth, or has a novel concept. Our friends and family members talk about the stock because it is in the hottest industry today.
But most times, such stocks will prove to be a less-than-satisfactory investment.
A few things are at play here. One, because of their promise, the hype factor and the fact that many people are chasing after them, the prices of these stocks or asset classes are bid up. They become expensive.
Two, because their prices are bid up and the market’s expectations for them are so high, everything must go right for them. Any little disappointment – and they will definitely run into some – will cause the stock prices to fall. The higher they are, the further they can fall.
Three, being the darlings of the stock market does something to the managements of the companies. Their egos become a bit bigger, they take a few more risks and they become a tad more tyrannical. Thus, the seeds of their downfall are sown.
Studies after studies have shown that, on average, investing in stock-market darlings, buying into high-growth companies, chasing after the latest investment fads, does not pay. Instead, it’s the boring stocks, the neglected stocks, the shunned stocks, that give investors the greatest upside.
Contrast companies that promise world domination with the unexciting ones that cough up consistent cash flows without the need for massive capital expenditure on a regular basis. Without a doubt, the latter group is a much better bet.
Which stocks have been the best performers on the Singapore Exchange in the past 10 years? They include the likes of Dairy Farm, the pan-Asian retailer that runs the Cold Storage chain in Singapore; Vicom, the largest technical testing and vehicle inspection firm in Singapore; and Raffles Medical Group.
An investment of $10,000 in Dairy Farm 10 years ago would be worth about $240,000 today, with dividends reinvested in the stock. Not too shabby.
(Createwealth8888: I won't believe too much in this "dividends reinvested" theory. In real investing, it is damn difficult to achieve. Reinvesting at same CAGR is far too difficult over market cycles)
There you have it – you can have your cake and eat it. You can get good returns, without taking on a lot of risk. So a strong conviction is required.
Just a note: Some of the stocks mentioned above have risen so much in the past 10 years, they might not be that cheap anymore. Hence, they might not be as “low-risk” as before. And their returns are unlikely to be as spectacular as in the past 10 years.
And so, the search continues for the next batch of safe and good stocks.