I have a tower next to my house with a security light mounted on it about 50 feet in the air. I live in a rural part of the county and when I built my house back in the late 70s cable was nowhere to be found, not being as common or popular as it is now (cue background music with Barbara Mandrell singing "I Was Country When Country Wasn't Cool"). In order to get TV reception I installed the tower with antenna and light. I installed it the old fashioned way, digging a hole, pouring cement and erecting it by hand.
Now the entire light has gone bad (the antenna no longer used) and I was trying to determine the most efficient and modern way to replace it, hire it done, do it myself, or find another alternative. Being an independent minded person I was leaning toward doing it myself but I kept thinking about the risk in doing that. After all, I'm not as young as I used to be and shimmying up a 50 foot tall tower isn't that appealing any more. Thinking about risk and efficiency made me think of efficient markets and investment risk (my mind works weird that way). I've written previously about risk but let's look at it again since I don't think an investor can over-emphasize risk considerations.
Efficient Market Hypothesis
Efficient Market Hypothesis, or EMH, essentially states that the participants in the market share roughly equal access to all relevant information and because of their collective efforts this information is fully reflected in stock prices. Since these participants will quickly move to buy cheaper assets and sell higher priced ones stocks are always priced fairly.
Out of this comes the view that one can't beat the market because one can't consistently move quickly enough to find stocks that are temporarily mispriced. Consequently, some stocks have to be priced, relative to others, to offer higher returns to attract people to consider buying them.
The upshot of this theory is that achieving success in investing, which in EMH means higher returns, is not a matter of investing skill, but rather in taking on higher risk. This is reflected in what has become the most well known risk reward graph as shown below.
As this chart shows the theory is the farther one goes out on the horizontal risk axis the greater the return as indicated by the capital (center) line and the vertical return axis. This exemplifies the belief that the different success rates between multiple investors is attributable to the differences in investment risk taken by each. I disagree with this and here's why. If the riskier investments always exhibited higher returns then they wouldn't be riskier, they would be more reliable. But they're not more reliable, except sometimes during bull markets when everyone's a genius.
This chart is a prelude to the concept of risk adjusted returns. Risk adjusted returns are when you account for the risk taken in achieving a particular return. If you go out to some point on the risk axis and you achieve X% return for that risk, how do you account for the risk you took to get that X% return? Enter modern portfolio theory, or MPT.
Modern Portfolio Theory and Volatility
With MPT risk is the chance an investment's actual return will not be what is anticipated, but its main metric, and what in essence has become the default definition, is volatility. Using volatility as a risk proxy provides a quantifiable way to measure for risk. Probably the most common method used in MPT is the Sharpe ratio. This is the investment's excess return above the risk free rate (normally the shortest U.S. T-bill rate) divided by the standard deviation of the return. Since standard deviation is a measurement of dispersion the wider the returns are from the mean or expected return, the greater the standard deviation, and hence a higher risk. A lower standard deviation would mean a greater probability of returns falling in the expected range. Standard deviation measures the variation in returns but as used in the Sharpe ratio does not necessarily, in my opinion, indicate the risk of actually losing money. Therein lies the problem.
The Sharpe ratio is measuring volatility but it doesn't differentiate between upside and downside volatility. I believe most investors are okay with upside volatility but are risk averse to downside volatility. The downside volatility is where investors tend to get emotional and all too often take actions that lead to realized losses. It's been shown that the greater the volatility the larger the percentage of investors who will close out their investments at a loss. We only need look back at 2008 to verify that.
There are other methods that use only downside volatility, such as the Sortino ratio, with the intent to distinguish between good and bad volatility. But there are other risks that aren't captured by volatility measurements, usually referred to as hidden risk. These include things such as liquidity risk, credit risk, and leverage risk. As an example, leverage risk may occur when a fund takes on too much leverage, such as Long Term Capital Management did before they went bankrupt. Individually an investor can take on too much leverage in a particular investment, such as margin, and a margin call results in the investor losing money, even though the investment may have low volatility.
Using standard deviation is supposed to tell you what kind of swing in the return you can expect. For instance, if your average return is 10% and the standard deviation is 15% then you can expect the return to be anywhere from -5% to 25%. But does that range of potential return really tell you how risky the investment is?
If you were asked, which is the riskier investment Procter & Gamble (NYSE:PG) or the SPDR Select Financial ETF (NYSEARCA:XLF), would you select XLF because it's a financial product made up of about 80 financial companies, and may have a larger standard deviation than stodgy old PG? If you had to choose between The Coca Cola Company (NYSE:KO) or Alcoa Inc (NYSE:AA), would you say Alcoa was more risky because it's a cyclical stock? What about Apple (NASDAQ:AAPL) or Microsoft (NASDAQ:MSFT), which one of those is the riskier investment? Using standard deviation we see that PG (12.50%) and KO (14.50%) both had higher standard deviations than XLF (8.60%) and Alcoa (11.30%). And if you said Microsoft (22.1%) was more risky than Apple (29.50%) you're using some means other than volatility to make that determination.
Theoretically those with the higher risk should provide a greater return. Did they? Looking at the annual returns you would see that PG returned 28.30% which is 14% less than XLF's 42.30%. And while KO with 2% was more than Alcoa's -4.80%, Microsoft with 11.3% was 35% better than Apple's -24.30%. This indicates to me there's still a certain amount of art involved in analyzing the science of volatility risk. Note: these returns are from 8/1/2012 to 7/31/2013 and include dividends.
Another measure of volatility is beta, which I do use but not as a measure of risk. Beta is how volatile a stock is in relation to the market as a whole. I look at beta to give me an idea of what kind of volatility I can expect from a certain stock but I don't think of it in terms of risk, but rather in terms of how smooth the ride will be while holding the stock.
It is not my intent to denigrate volatility measurements or minimize the use of them in investing. They have their place and their adherents. However as a dividend growth investor volatility just doesn't have the same importance as a measurement to me as it would to an investor focused primarily on return. This is difficult for some to understand, but it's because I define risk as the loss of income, not as a reduction in return or even the failure to achieve an expected return.
By loss of income I refer to the income being in peril. The MPT or total return investor might argue that price volatility places returns in jeopardy, and that might be true if one is focusing on volatility and those unrealized gains. Some may say that the potential for capital loss due to price declines would impact my income but that assumes I would sell due to price declines. But since I focus on income a price decline, or its accompanying volatility, does not necessarily impact the income, or even place it in peril (at risk), and it doesn't make me want to sell as long as the income continues unabated.
Dividend Growth Investing and Risk
So how, as a retired dividend growth investor, do I measure, monitor and reduce risk? I use multiple criteria that I believe added together makes the whole greater than the sum of its parts, and reduces my risk. As a retired DGI my goal and focus is to receive and grow income from my investments. I measure dividend growth rates that tell me if the income is growing and if so at what rates. If a company such as Johnson and Johnson (NYSE:JNJ) has been paying a dividend for over 50 years that tells me there's a pretty low risk that it'll be cut without some significant event happening. So I can then monitor for those events. And since JNJ has 1, 3, 5, & 10 year growth rates of 6.75%, 7.5%, 8.2%, and 11.7%, I watch those rates for indications of unacceptable decline.
I calculate and watch dividend payout ratios to make sure the dividends are safe. I make sure I understand how the company makes money, and then I monitor to see that it continues to do so, growing earnings and free cash flow. As a dividend growth investor my intent is to buy quality companies when they are at or below their intrinsic value, to not trade in and out of them based on price volatility, but simply to hold them and monitor their continued worth to the portfolio.
I look for companies with sustainable competitive advantages. I diversify and limit position sizes. Lastly I make sure I understand my own risk tolerance. Benjamin Graham suggested that the individual investor limit his ambition to his capacity and confine his activities within the safe and narrow path of standard, defensive investment. To me that's Dividend Growth Investing.
Understanding your personal risk tolerance is more than thinking about how you will handle a pullback. It would be easy to say someone's risk tolerance is higher if they held through the 2008-2009 recession but is that necessarily so? Could it be that they had a different view of risk, that they believed the probability of taking a loss was greater from selling than from holding? Why should they sell if their companies were still making money, growing cash, paying dividends, and meeting their income objectives?
Could it be their portfolio with DGI holdings such as McDonalds (NYSE:MCD), PG, JNJ, and KO, among others, was declining less than the benchmark S&P during the meltdown as indicated by this chart from late 2007 to early 2009:
In talking about the "superinvestors" of Graham and Doddsville, Warren Buffett said they assumed far less risk than average because although they had different styles and different portfolio positions, they mentally were always buying the business, not the stock, and they all exploited the difference between the market price of a business and its intrinsic value. To quote Buffett, "Risk comes from not knowing what you're doing."
You manage your investments by managing your risk. Investing requires balancing both risk and reward, and deciding what action to take, whether to buy, sell, or hold, is part of managing the risk that is inherent in investing. Even not taking action can be risky, such as holding cash and losing ground to inflation. As someone once said, risk free is also return free.
Risk is not just a matter of volatility. Risk is personal. It has to be considered in relation to our own individual circumstances, our age, our investing experience, how much capital we have at risk, whether we're in the accumulation phase or distribution phase of investing, our emotional ability to handle drawdowns and so forth. If we overestimate our ability to understand a company or the implications of an investment, if we think our ability to withstand volatility and ride out a significant pullback in price is greater than it actually is, we just increased our risk.
To my way of thinking risk is the single most important consideration in investing. Risk is always there, beside and inside each of us. In reality, if we really want to see what risk is, we just need to go look in the mirror. It'll be staring back at us. Which is what my wife says when I talk about climbing that tower.
Disclosure: I am long JNJ, KO, MCD, MSFT, PG. 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.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.