What is Risk?
My last article addressed the topic of managing panic when a position or investment starts moving against an investor. In my opinion, panic, or the inability to manage the emotions involved in investing, creates risk to an investor.
Webster's defines risk as the chance (degree or probability) of injury, damage, or loss. Without doing a survey or any academic study, I believe if I asked typical investors how they defined risk, their response would be "losing my money" when the price of their stocks goes down. But as a dividend growth investor looking for income, I believe we need to take a different approach to how we view and how we manage our risk. I'll even go so far as to call it a common sense approach.
Modern Portfolio Theory, or MPT, puts risk in two basic buckets, systematic risk and specific risk. Systematic risk is when the entire market moves down such as in 2008/09. Specific risk is when a specific component, such as an individual stock or fund, moves down. It manages risk in these two areas through asset allocation or diversification, spreading investments across various assets such as domestic stocks, international stocks, emerging markets, bonds, T-bills, mutual funds, etc. Ultimately though, at least in my opinion, it uses price volatility as its primary determinant for how it measures risk.
Dividend growth investing has similarities to MPT, but approaches the overall aspect of risk differently. Dividend growth investors will use diversification, but it will typically be across a number of individual stocks in multiple sectors/industries, and possibly a portion of REITs, closed-end funds, and master limited partnerships, all with the objective of receiving income from dividends. Dividend growth investors may even have a portion of their portfolio set aside for growth stocks that may or may not pay dividends. But the determining factor in measuring risk for long-term dividend growth investors should be and is different than simply using price volatility.
How I Define Risk
I define and approach risk as loss of income because my objective from investing is income. That does not mean I ignore pricing, it's just that my primary focus is on income. I also want capital growth, but I am more concerned about the safety of that income and so I manage my investments to that end. Those whose objective is simply capital appreciation or total return may define risk as loss of capital, and approach measuring risk by using price volatility, especially if their timeframe for holding is a short period. I measure risk as a dividend cut, or when income stops growing such as a dividend freeze, if the dividend growth rate falls below the inflation rate, if the company may be having financial difficulties, or may be having management issues. My risk tolerance to a great extent is determined by the makeup of my portfolio. If I have 25 positions equally weighted and I lose 100% of any one position, then I've lost 4% of my total portfolio. But I manage that 4% risk by monitoring the companies I'm invested in for their fundamental soundness. As Warren Buffet has said, "If a business does well, the stock eventually follows."
My broker's website shows both my unrealized and realized gains and losses for the year to date. If I see a position that's showing an unrealized loss of say 20%, have I lost 20% yet? No, but I have a risk of losing 20% if I sell, and if I ask myself what has changed in my position other than the price, then it changes how I view the risk to that particular position. If I entered at a price above value, that doesn't mean I take a loss and sell just because price goes down. Am I still collecting the dividends or receiving the income? Is the company still sound? The unrealized loss it may be showing is based on the entry price, but if I've been collecting dividends my cost basis may be lower than the current price. Using the definition of risk as noted earlier, to me my real chance of loss is the potential loss of monthly or quarterly income, not the fact that the price is now down.
The same is true if it's 20% above my entry price. Have I made 20% yet? No, but I have an opportunity of making 20% if I sell, but that doesn't mean I should. I again have to ask myself the same basic questions - Is it still fundamentally sound, am I still collecting dividends, what's my objective for this investment? If a position is overvalued, I may take profits on all or a portion of the position and reinvest those proceeds into another income candidate. But if I sell to reinvest without having a replacement candidate, then I've just reduced my income upon which I may be dependent. So there is still risk to my income that needs to be acknowledged, understood, and managed.
Understanding My Risk Profile
I think it's important that each of us know our risk profile. What does that mean? It means that I have determined in advance how I define risk, how I measure it, what my investment time frame is, and how much risk I am willing to accept at any given time. Traders use a risk/reward profile predicated on price and position size. As a dividend growth investor, mine is based on the income and income safety, the fundamental soundness of the company in which I'm invested, the investment timeframe, and the position size of the investment. If I'm in an investment and it starts pulling back, my risk profile helps me decide when to exit. I'm long Intel (NASDAQ:INTC) and it's recently been pulling back. I don't view that as a reason to exit but rather as an opportunity to add to my position because the company is still fundamentally sound. Only the future will tell me if I'm right or wrong, but in the meantime I'm collecting income. QE3 may even provide additional opportunities for adding to positions if investors start moving out of boring but safe "risk-off" companies into more "risk-on" companies.
Part of my risk profile is my "perception" of risk such as in my Intel example. If nothing has changed fundamentally with a company other than price and I start getting anxious, the perception of risk is caused by my reaction to the price volatility. If I haven't properly structured my portfolio to limit risk, then the size of a position can affect how I view risk. Putting it another way, if I focus solely on the price, then the volatility of pricing can create anxiety, and to a great extent drive my actions and lead me to make mistakes. Letting price volatility alone drive my perspective of risk will lead to, in my opinion, "stinking thinking."
I may also create risk by not performing due diligence prior to entering a position as well as after I enter a position. Due diligence prior to entering a position not only includes fundamental analysis but it must also include an understanding of how other factors such as systemic risk, sector rotation, industry regulations, governmental policies, etc. may affect it as well. I must also perform due diligence after I enter a position. If I don't do my due diligence after I enter a position, such as described here, then I am also increasing risk. Monitoring one's portfolio and making sure that the positions are still meeting the goals and objectives of your investment business plan is an essential part of being a successful investor. It's even more so if you're dependent upon the income.
Managing risk is not easy and I don't mean to imply that it is. Nor do I mean that we should ignore pricing as a risk component. I'm not advocating holding on to losers, but there is more to defining a losing position than just price. There's a psychological aspect to risk management, and short-term price fluctuations can be a constant thorn in the side of many investors. In my opinion, understanding and managing your risk tolerance so that market or price fluctuations don't change how you view your investments is critical to being a successful dividend growth investor. One of the reasons I select low beta stocks such as Coca-Cola (NYSE:KO), McDonald's (NYSE:MCD) and Southern Company (NYSE:SO) (which have 36-month betas of 0.44, 0.30, and 0.13, respectively) for my portfolio is because they typically will have a lower level of price fluctuations than the overall market. For my "growth" positions with higher betas, I limit them to a smaller portion of my overall portfolio. By doing this, it helps me stay within my risk tolerance while focusing on income.
Mark Twain said, "I am an old man and have known a great many troubles, but most of them never happened." Over the years, I've sold too many positions on the basis of risk that never happened. I found I was most successful when I stayed invested, not by trading in and out of positions because of price volatility. To do that, I had to wrap my mind around the idea of risk so that I understand what it is and what it isn't, when risk is actually present and when it's not, and how much I'm willing to tolerate. I have to be able to know when I'm the one creating a perception of risk that isn't there, as opposed to when it's real and valid. I cannot control price volatility, but I can control how I react to it, how I view it, and how much consideration I give it in regard to my investment objectives. I think that's a common sense approach to managing risk, I believe dividend growth investing is a common sense approach to investing, and my greatest risk is if I stop using common sense.
Disclosure: I am long INTC, KO, MCD, SO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.