What Does Risk Mean To You?

by: Eli Inkrot

The way I see it, there are three basic types of risks in the equity investment world: sitting on your hands, relying on what other people are willing to pay, and owning a collection of profitable dividend growth companies. Personally, given that you are forced to be exposed to at least one of these risks, I would pick the last one. Perhaps I am simplifying things a bit, but you will be able to follow my reasoning soon enough.

"Sitting on Your Hands"

So what exactly falls into the risk category of "sitting on your hands"? I would qualify this risk as any money that is sitting under your mattress, either literally or figuratively. More specifically, this would be any money that you have able to be invested that is either in cash or a low-interest account. Now to be perfectly clear, I am not talking about your emergency fund. The psychological and economic benefits of an emergency fund are immense. I'm not even talking about your vacation fund or money you might set aside every month for a few nights out on the town. I am specifically talking about money that is above an emergency fund along with any other upcoming expenditure, but is not invested.

Often times these types of low/no interest assets are considered "risk-free". Things like cash, a savings account, certificates of deposit or treasury bills. After all, the principal within these investment vehicles is in fact "risk-free". That is, one does not need to be concerned that the nominal value of their principal will go down in the future. People take comfort in knowing this. They shouldn't. The real opponent within wealth creation is not preservation of capital, but rather what I like to call "Old Man Par", or inflation. A simple example will better illuminate this idea. Imagine you have $1,000 sitting in a 5-year CD that is paying 1%. In five years time, your principal will not deteriorate, but will in fact grow to a value around $1,051. At the same time, imagine that inflation runs at 3% a year. That $1,051 isn't worth $1,051 in today's purchasing power five years from now, but is instead worth about $906.61 in today's purchasing power. More generally, by using the CD investment, you will be able to buy less stuff in five years than you could today. By agreeing to an investment that is yielding less than inflation, you are guaranteeing not just principal but more importantly a loss of purchasing power over time.

This is precisely why people gravitate towards "riskier" investments. In reality, "risk-free" investments are riddled with risk, while "riskier" investments, like stocks, are the path towards alleviating the indicated risk. Within stocks, allow us to differentiate between non-dividend paying and dividend paying stocks.

"Relying on What Other People Are Willing to Pay"

Non-dividend paying stocks have the risk of "relying on what other people are willing to pay." Surely the stock prices of non-dividend paying companies are closely correlated with the companies' underlying profitability over time. That is, the more money a company makes and looks to make in the future, the more likely it is that the market will eventually price the stock accordingly. However, I personally find two very specific risks with this approach. First and foremost, one is relying on what the market is doing at the time. If you happen to need some income for whatever reason, you are at the whim of whatever people are currently willing to pay. Furthermore, even if you don't plan on selling shares of non-dividend paying stocks today, it might take a while for the market to price the potential that you see. For that matter, the consensus might never agree with you.

The second unfortunate resultant that I see is that to make money from your investment in non-dividend paying companies, eventually you will have to sell shares. I become a part-owner of businesses because they make money and will make more money in the future. Perhaps I am in the minority, but it seems illogical to sell a company for precisely the same reason. After all, the market is likely to be pricing the stock highest when they expect the company to make more money. Even if the market efficiently prices the potential I saw and I decide to decrease my ownership stake in a profitable business, how do I determine when it is the right time to sell?

The risk that I am referring to is often quantified as 'standard deviation'. My favorite graduate investments professor (to be complete, my only graduate investment professor) is probably most recognized by this oft repeated 3-line phrase: "volatility erodes wealth". A simple example will better illustrate his point: Imagine that you have $100 invested. In the first period, you earn a 10% return and in the second period your investment declines by 10%. Where does that leave you? At first glance one might imagine that you are back at your original $100. However, the math dictates that you actually lost a dollar. In the first period, you are up to $110, only to have $11 taken from you in the second period for a two-period total of $99. It works the other way as well; if you lose 10% to start and gain 10% in the second period, you still come to a total of $99. Moreover, the more volatile that the arrangement is, the more one will see their wealth eroded. For example, moving up/down 20% on that same $100 yields an end result of $96, while an up/down movement of 30% results in $91 after two periods. It is interesting to note that while your average return in these scenarios is 0%, you are losing wealth. In fact, given these examples, it would be much better to literally have 0% returns rather than to average a 0% return.

But of course people don't invest in the market in the expectation of averaging a 0% return, much less losing wealth over time. However, the underlying principal is very much in play. For example, a 12.85% average return with an underlying standard deviation of 20% actually equates to a yearly return of about 11%. Quantified, if one were to assume a linear 12.85% return on $10,000 for 10 years this would turn out to be about $33,500. On the other hand, the true 11% return on $10,000 for 10 years turns in to about $28,400; a $5,100 difference that would be difficult to observe without doing the applicable math. For non-dividend paying stocks, one must concern their selves with fluctuations in stock prices.

"Owning a Collection of Profitable Dividend Growth Companies"

On the surface this doesn't seem like a risk at all. But all decisions related to equity investments do carry risk. By not investing, one is likely losing purchasing power over time. By investing in non-dividend paying stocks one is likely lending themselves to the rationality/irrationality of what others might or might not be willing to pay for your ownership stake. By investing in a collection of dividend growth stocks, the risk comes in the form of the businesses relinquishing their decades of profitable endeavors. It should be noted that I am using "dividend growth stocks" as a proxy for dividend paying stocks. While there is a very important difference, the associated risk is relatively similar.

Let's say that you own a small portion of the following companies: Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Procter & Gamble (NYSE:PG), Colgate-Palmolive (NYSE:CL), Johnson & Johnson (NYSE:JNJ), Chevron (NYSE:CVX), Exxon Mobil (NYSE:XOM), Kimberly-Clark (NYSE:KMB), AT&T (NYSE:T), IBM (NYSE:IBM), Walgreen (WAG), Wal-Mart (NYSE:WMT), Target (NYSE:TGT), McDonald's (NYSE:MCD) and Emerson Electric (NYSE:EMR). Now obviously I can not tell you what will happen in the future. But if I held a collection of companies similar to these holdings (I do) then I would feel very confident about my future dividend income stream; as each of these companies has not only paid but also increased their dividend payout for anywhere between 17 and 55 straight years. More than that, they have usually done so by a rate that far outpaces inflation. Additionally, an equal share in these 15 companies would create an initial yield around 3% today. Certainly one can do even better than this, but that's not bad for pulling a few names out of "dividend growth thin air".

While the non-dividend paying investor has to be concerned with required returns and what other people are willing to pay, the dividend growth investor is likely only concerned with a growing stream of income. The risk then, comes in the form of one of these companies decreasing or cutting their dividend. More specifically, the risk comes in the form of very profitable businesses suddenly stopping their long and storied records of making money and rewarding shareholders. If forced to face a risk, this is the one that I want to be exposed to.

Imagine you invest $60,000 equally into 30 dividend growth companies with an average yield of 3% and an expected dividend growth rate of 6%. (Not particularly difficult to find) This year you will make approximately $1,800 in dividend income. If everything goes as planned, next year you will make $1,908. In the third year, you will make $2,022 and so on. But what happens in the unlikely event that one of these companies cuts their dividend? In fact, let's say they get rid of it altogether. This would mean a loss of $60 in income (assuming a 3% yield), which is the only thing that you are concerned with. In the first year, you only make $1,740. But in the next year if the other companies all increase their dividends by 6%, you will make $1,844. In the third year, you will make $1,955 and so on. It should be reassuring that even if a company with a long track record of increasing their dividend gets rid of their payout, your income producing collection is only causally affected. The risk comes in the form of a dividend reduction or cut, but given a wide enough basket of income machines, even this does not need to be an inhibiting concern.

To complete this example, imagine the worst possible scenario for the non-dividend paying investor: all of their holdings go to $0. That is, the market decides there is no hope and they are not willing to buy your ownership claims at any price. Surely this is an exaggeration, but the lasting implication is important. If this scenario were to happen to a collection of non-dividend paying stocks, then you would be in a heap of trouble. But what if this happens to a collection of dividend growth stocks? In reality, as long as one is only concerned with a growing stream of income, this $0 valuation has no bearing on the success of the dividend growth portfolio. As long as the business remains profitable and continues to increase dividends, as an investor you're good. This year, you bring in $1,800, the next year $1,908 and so on. In fact, going back to basic time value of money calculations, it would be ludicrous to think this portfolio is ever without value.

A more realistic application of the risk involved with a dividend growth portfolio is the opportunities that it provides. For example, both "sitting on your hands" and "relying on what others are willing to pay" requires you to be overly concerned with your underlying principal. However, with a growing stream of income, you don't really care what other people might be willing to pay for your ownership claims. In fact a decreasing or stagnating stock price could be the best thing to happen to your investments in the short-run. It is important to understand both your underlying investment thesis and the applicable associated risks; as Warren Buffet says: risk comes from not knowing what you are doing.

Disclosure: I am long KO, PEP, PG, JNJ, IBM, WAG, TGT, T, MCD.