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  • Basic Forms Of Risk 15 comments
    Aug 14, 2013 7:59 AM

    In recent weeks the Dow Jones Industrials have continued to hit new all-time highs. According to the Wall Street Journal, the Dow has hit a new high 28 times this year.

    The higher the market goes, the more people worry about a market correction. Just how much more riskier are stocks now than other investing opportunities? I suppose it all depends on how one defines risk.

    Before I get into defining risk from my point of view, let me share some food for thought. It has been reported that Warren Buffett's Rule #1 is to not lose money. He is also reported as saying that one should not own a company that would cause us to sell on a 50% pullback.

    So which is it? Don't lose money or don't sell on a 50% pullback? ... I believe it all comes down to how you define risk. I think I understand how to not lose money and still be able to withstand a 50% pullback.

    I believe that risk takes two very basic forms and everything else is an offshoot of those basic forms of risk. They are referred to as "Shallow Risk" and "Deep Risk."

    I recently read an article in the Wall Street Journal by Jason Zweig, where he wrote about these basic forms of risk. According to Zweig, William Bernstein, an investment manager at Efficient Frontier Advisors, calls "Shallow Risk" as a temporary drop in an asset's market price. Key word being "temporary." Benjamin Graham, author of The Intelligent Investor, referred to a temporary loss as "quotational loss."

    "Shallow Risk" is as inevitable as the weather. You can't invest in anything other than cash without being hit by sharp falls in price. "Shallow" doesn't mean that the losses can't cut deep or last long ... only that they aren't permanent.

    "Deep Risk" on the other hand is a loss of capital that you won't recover for decades ... if ever. The four causes of deep risk are inflation, deflation, confiscation and devastation. These forces can make assets lose most of their value and never recover.

    Bernstein says that we should insure against deep risks based both on how likely and how severe they are. For example, if you live in a flood zone, you should insure against flood before anything else.

    As you break down the causes of deep risk, devastation would include war or anarchy. There isn't much that you can do about it. As far as I'm concerned, it is a risk I can ignore, other than not investing in countries with unsteady regimes or no law and order.

    Confiscation can be attributed to a surge in taxation, or a seizure by government as happened to bank deposits in Cyprus.

    For the most part, we can manage our assets for most taxes, but we must be aware that tax changes involve deep risk. A change to the tax laws regarding REIT's and MLP's would be a good example. So, we may want to keep those positions in proper perspective within our portfolio's.

    Deflation is the persistent drop in the value of assets and is very rare in modern history. It has hit Japan, but almost nowhere else in the past century, due to central banks that print money to drive up prices.

    If one is concerned about deflation though, the best place to put your money would be in long-term government bonds. You could also get foreign exposure via equities since deflation isn't likely to hit all nations at once.

    However, since bonds protect you from deflation, they expose you to inflation ... by far the likeliest source of deep risk.

    Bernstein said that inflation can destroy at least 80% of the purchasing power of a bond portfolio over periods as long as 40 years. That is deep risk at its deepest. --- In my opinion, dividend growth is the best hedge against inflation. This does of course expose you to shallow risk.

    Most people who promote asset allocation would want us to have a globally diversified stock portfolio with some gold and natural resources companies, some treasuries, inflation protected securities and bonds. But holding stocks to insure against deep risk drives your shallow risk though the roof. While stocks should protect you against inflation in the long run, they are guaranteed to expose you to price drops in the shorter run. That could push you into the final frontier of deep risk ... your own behavior.

    Most investors can't survive the pain of plunging prices unless they have a surplus of cash, capital gains and courage. When you have plenty of each, you can hang on and endure price drops like we experienced during The Great Recession. I found that when you own quality blue chip type companies, that the risk I was taking on was in the shallow risk category. In other words, losses were temporary.

    If one sells quality in a declining market, one is thereby inflicting a permanent loss which comes under deep risk. In a lot of situations, it's your behavior that is more at risk than your holdings. Your behavior can turn shallow risk into deep risk in a heartbeat.

    This is why I continue to harp on owning quality blue chip companies. These companies have survived decades of adversity and continue to bounce back correction after correction. If the blue chip companies don't come back after a market correction, nothing will. If I can eliminate deep risk, I can handle shallow risk. After all, the loss from shallow risk is only temporary.

    Take the advice of Warren Buffett. Only own companies you would feel comfortable owning, and adding to, if they were to suffer a 50% pullback. That's how you meet Rule #1 ... don't lose money. Focus on best of breed!

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Comments (15)
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  • SDS (Seductive Dividend Sto...
    , contributor
    Comments (3234) | Send Message
     
    Chowder,
    Thank you for good blogpost.
    Can you provide link to paper in Wall Street Journal by Jason Zweig please?

     

    Although whole stock market can have 50% pullback, more often it happens with a single stock price or dividend. Even "quality blue chip companies" are not sustainable from 50% dividends cuts, although their prices usually do not drop 50% in 1 day, so the answer to this risk is well known /I even would not name it 8-) /.

     

    Recovery of prices or dividends are happens but I guess time of recovery is hard to predict - some historical data presented in (see http://seekingalpha.co....

     

    "Confiscation can be attributed to a surge in taxation". - Yes and dividends were the target quite often, so IMO dividend investors should be active and contact their government reps about tax policy. I lived in communist country there confiscation was almost legal even most of people dislike it.

     

    BTW, recently good article on the subject appeared at http://seekingalpha.co..., there main risks for dividend investors are specified as

     

    * Unforeseen and unplanned for events might necessitate the need to sell shares of stock in the portfolio. This will impact the income stream.
    * Hyper inflation takes hold and the dividend stream is less able to keep up. This will reduce the purchasing power of our income.
    * The Government decides to raise all taxes on all forms of dividends. This action will also erode the value of our income stream.
    * The dividend champion stocks either reduce the percentage of increases per year or just stop the dividends completely. This would be terrible when combined with increased taxes and hyper inflation.

     

    Although I would agree that "dividend growth is the best hedge against inflation." for modern inflation I don't know appopriate shield against hyperinflation. Again I faced it in my "previous" life and it is terrible. Monetary policy in last few years (in USA and EU) might lead to hyperinflation in next decade, so any this topic seems me important.

     

    SDS
    14 Aug 2013, 09:50 AM Reply Like
  • chowder
    , contributor
    Comments (7416) | Send Message
     
    Author’s reply » SDS, I don't have a link to the article as I don't subscribe to the WSJ. I happen to have a copy I picked up at the news stand at the airport. The weekend edition of July-27-28.
    14 Aug 2013, 09:55 AM Reply Like
  • Chumpmenudo
    , contributor
    Comments (629) | Send Message
     
    I subcribe, but couldn't find the text. Here is a link to a video of Jason explaining the risk concepts: http://on.wsj.com/1cNKJKE

     

    Best,

     

    Chump
    14 Aug 2013, 12:34 PM Reply Like
  • sheldond
    , contributor
    Comments (1081) | Send Message
     
    Chowder,

     

    Good advice regarding risk. I might add that when you combine what you said with buying at a relative value....you have it all covered. I ussually look at risk as price to value.
    14 Aug 2013, 09:50 AM Reply Like
  • Chumpmenudo
    , contributor
    Comments (629) | Send Message
     
    Hello Chowder:

     

    Great article on an interesting topic. I like the shallow and deep risk concepts; I personally think of risk as the chance of permanent value impairment leading to a sub par return or loss. I also think it worth mentioning, that by my definition, the same security can have differing levels of risk based on entry point. For example, I believe buying CL today at a PE over 25 would be very risky, even though it's an amazing blue chip company, versus buying when the PE is lower, say in the mid to high teens. The lower entry point offers the coveted "Margin of Safety" against an unknowable future.

     

    Best,

     

    Chump
    14 Aug 2013, 12:31 PM Reply Like
  • SDS (Seductive Dividend Sto...
    , contributor
    Comments (3234) | Send Message
     
    Chump
    Thanks for the link. It seems that they play semantics and "look in rear mirror".
    SDS
    14 Aug 2013, 02:02 PM Reply Like
  • chowder
    , contributor
    Comments (7416) | Send Message
     
    Author’s reply » I got it! ... Here's the link to the article!

     

    http://on.wsj.com/13AB5CB
    14 Aug 2013, 02:38 PM Reply Like
  • SDS (Seductive Dividend Sto...
    , contributor
    Comments (3234) | Send Message
     
    Thank you, chowder! WSJ paper is indeed quite shallow but William Bernstein wrote good books, so let's wait his book on deep risk to see if there is beef in the story.
    SDS
    14 Aug 2013, 07:01 PM Reply Like
  • chowder
    , contributor
    Comments (7416) | Send Message
     
    Author’s reply » The article was quite clear to me, based on my experience.

     

    When you own quality, and nothing has changed fundamentally within the company, then any pullback in price, as long as the rest of the sector is pulling back as well, is shallow risk.

     

    Inflation must be offset, so I understand the deep risk involved there. I don't think there is any question that REIT's or MLP's would take significant price cuts if the tax laws favoring them change, and those losses would take a long time to make up, I would think. Deep risk!

     

    I know people personally, that I tried to talk into not selling during the Great Recession, and they sold anyway. They never came back into the market. They turned shallow risk into deep risk.

     

    Is the idea of VZ going into Canada, causing Canadian telecom's to take a price hit, considered shallow risk or deep risk? ... I don't know the answer to that one. I know I don't trust the Canadian government after the way they shafted those who held Royalty Trusts and now they won't allow Canadian companies to consolidate and grow.

     

    Depending on how long one is willing to wait, I would assume it's shallow risk, but it could take a couple of years to confirm it.

     

    I suppose there are some risks I'd rather not take on, shallow or deep. That's why I stick with quality companies, the leaders in their industry. I improve the odds that most price action is of the shallow risk nature.
    14 Aug 2013, 07:25 PM Reply Like
  • rnsmth
    , contributor
    Comments (1958) | Send Message
     
    I sold BCE rather than to wait to see what happened. Deep, shallow - I don't know. I considered it unneeded risk.
    15 Aug 2013, 01:16 AM Reply Like
  • chowder
    , contributor
    Comments (7416) | Send Message
     
    Author’s reply » Unneeded risk, I agree. There are some risks I simply don't wish to take regardless of how good the story is.

     

    Speculation is another risk I'm unwilling to chase. As I get older I realize that those starting earlier enough in life can become wealthy simply by sticking with conservative companies, reinvesting the dividends and allowing compounding to work for them.

     

    Speculation tends not to work as often as it does work. It's why it's called speculation. I don't like the odds anymore.

     

    I know a lot of people at or near retirement invest in CEF's for their high yields. In a lot of cases, those yields are not covered by earnings. When the market is rising, it's exciting to receive those nice dividends. However, when the market has a significant correction, not only do the CEF's lose considerable market value, a lot of them have no choice but to cut the dividend as well. The odds are much higher for dividend cuts with CEF's than they are with high quality equities.

     

    I know people are different and some will think they are still getting a better yield with a CEF after a cut than with KO for example, but for me, I want something more dependable in retirement. I know I can count on KO to keep paying that dividend and growing it every year. I like that level of comfort. So, taking on the risk of CEF's is something I would want to keep at a minimum.

     

    BDC's and mREIT's are unneeded risks in my camp. I know there are some BDC's that are better than others, but my understanding, and I could be wrong, is that they lend money to companies that the banks won't. So to me, although a BDC may take on the better of less than investment grade, the whole concept is based on less than investment grade, and that's counter to my regular stock selection process. So I avoid it.

     

    Inflation is the most likely of risks we face going forward and mREIT's are set up where it will make inflation look like it's on steroids.

     

    These unneeded risks, although I don't wish to take them, can be managed by others and I wouldn't criticize them for taking them. Some people are smart enough to keep unneeded risk to a small part of their portfolio.
    15 Aug 2013, 12:37 PM Reply Like
  • conkjc
    , contributor
    Comments (1557) | Send Message
     
    Chowder,

     

    I agree with you on Reits and those types of high yield investments. I guess those types of dividends are nice while they last. I guess I would equate those types of investments to building a beautiful home on the beach. The view is amazing until that hurricane comes. I'll take my dividends from bedrock companies that have and will continue to stand the test of time. In my way of thinking, the dividend is only valuable if it is sustainable for the long term.
    I also agree with you that people, especially younger people can do very well over the long term by investing in conservative companies (like PG, GIS, JNJ, KO etc) and reinvesting the dividends. To my way of thinking, why try to outsmart everyone when one can let compounding, time and inevitability drive the process.

     

    Jon
    20 Aug 2013, 08:19 AM Reply Like
  • drwerewolf
    , contributor
    Comments (12) | Send Message
     
    The fifth deep risk is buying a company that goes bankrupt and wipes out your equity.

     

    The sixth deep risk is buying a company that begins to permanently perform at a much lower level than it was performing at when you bought it. (Pitney Bowes f'r instance.)

     

    You already know this of course but it's worth mentioning explicitly....
    18 Aug 2013, 11:18 AM Reply Like
  • chowder
    , contributor
    Comments (7416) | Send Message
     
    Author’s reply » You're right of course drwerewolf. I covered that indirectly under owning high quality blue chips, but it's better that you spelled it out even more clearly. Thanks.
    18 Aug 2013, 03:06 PM Reply Like
  • sameer syed
    , contributor
    Comments (16) | Send Message
     
    chowder, one other form of deep risk is not investing at all or staying away from investing. Thanks
    2 Sep 2013, 01:35 PM Reply Like
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