- Risk management separates the business of investing from gambling with investments in the hope of making money.
- Here, I present the overall principles of risk management and how they work to convert a gamble into a zero probability of loss with targeted gains over 12% average annual.
- If your goal is to make as much money as possible, I lay out a path to do so, but identify the pitfalls that go with it.
- Looking for a helping hand in the market? Members of Engineered Income Investing get exclusive ideas and guidance to navigate any climate. Get started today »
Risk management separates gambling from business. For casino players, gambling is a risky venture. By application of principles of risk management, casinos turn risky gambling into a reliable business. To take the gambling out of your investing requires knowledge and application of the principles of risk management.
Today, I will introduce the principles of risk management for investors. Only by the application of these principles can you turn your stock market ventures from risky gambling into solid investment with 100% probability of successful returns.
First, let me discuss some important concepts in risk management generally. Risk can only effectively be managed at the portfolio level. Any given individual ticker investment is susceptible to black swan events that might take it from favorite growth to flat-busted broke. Warren Buffett is noted for saying that the key to successful investing is to "never lose any money". This may seem humorous at first, but it is truly deep wisdom.
What Mr. B. refers to is to focus on quality targets that have very low prospects of going out of business and buy them only at prices discounted from their true value. Do not confuse price for value. At any given moment, a great company may be trading at a real bargain, or an inflated bubble price, or somewhere near its fundamental fair value. If you focus on buying below fair value and the ability to hold through downturns so never forced to liquidate at prices below value, then you have very low risk of losing any money.
By doing this over a wide variety of tickers, even the occasional rare loss due to surprise fall in fundamental value will be offset by those other holdings that outperform and make up for such losses. Thus, the result at the total portfolio level with these simple rules is a positive total net outcome.
Just as evolution occurs not at the individual level, but rather at the species level (where statistical drift of the collective gene pool mean distribution is the mechanism underlying species evolution), so it is that growth (or loss) is experienced at the total net return of your portfolio, including the total sum of all realized gains, losses, dividends, and other realized revenues (such as option premiums, stock spin offs, etc.).
In my Tortoise series, Part 1 shows the work of J.D. Roth and his chart presenting statistical analysis of broad market SPY returns over time. It reveals a 100% statistical probability of achieving at least a 4% average annual return if invested for a minimum of 10 years, at least 6% if invested for 15 years, 10% for 20 year investors, and 12% or greater for investments of 25 years or more in the broad market indices such as SPY.
This highlights and confirms two key principles of risk management.
2. Time horizon of the investment.
There is virtually no possibility of SPY going to zero or even of declining without recovery over a period. In a long enough window (10 years or more from the chart), there is 100% statistical probability of no loss, 94% probability at 5 years even). So, if you manage your finances so you have sufficient reliable dividends, fixed income, salary, pensions, savings, and other sources to survive 5 years without being forced to liquidate your broad market investment, you actually are safer than even the safest bond. In fact, by 10 years investment, you will have at least a 6% average annual yield from your investments.
Can your no-risk bonds (US government bonds are considered the measure of zero risk) come close to matching these numbers? Perhaps you need to question conventional wisdom of the professional investment advisors and their suggestions that such bonds are safer returns than market investments. When risk management using diversity and time horizon are taken into account, the broad market investment can be expected to safely outperform any government bond and even most high-risk junk bonds. Clearly, there is no need to chase risky high yield from such things as shipping sector stocks like and leveraged mortgage REITs. Better yields at zero risk probability are available from something as simple as a SPY portfolio held for sufficient time.
When people hear that I am an investment analyst and writer, they almost invariably ask me what is a good investment idea. In turn, I reply "What is your goal?". The answer almost always is "To make the most return possible". Now, with their goal clearly defined, I then confidently suggest "23 red on the roulette wheel" (or any other single number). This of course shocks them, until I explain a bit further.
The stated goal was to make as much as possible. No limit on risk was put forth. Yes, the risk of hitting a single number on the wheel is 36:1 against you, but the reward is very high too, at 35:1 payout if successful. So, $1,000 put on a single number returns $35,000 on a single pass. Let it ride and a repeat hit turns the $35,000 into $1,225,000! Yes, just 2 in a row and your thousand has become over a million. Not likely to happen, but the stated criteria was to make as much as possible. Let's proceed to a 3rd hit in a row and the payout is $42,875,000. Wow, but still not Bill Gates or Warren Buffett size wealth. The 4th hit puts you into the billionaire class at a payoff of $1,500,625,000. So, yes, nowhere else will you find such high reward (balanced in fact by relatively low odds against you versus the actual odds against the repeat hits). However, the risk of success in 1 hit, let alone 4 hits, almost insures you will lose.
Consider the risk of finding the next Facebook (FB), Alphabet (GOOG) (GOOGL), Amazon (AMZN) or other FAANGs. You not only need to pick the one out of thousands of tickers, but also you need to buy at the right price and you need to hold all the way until it gets to that peak of peaks, avoiding weak knees in secular crashes, market corrections and bears, and other fumbles along the way. Do you really think you can beat the odds against getting all those things right in such a buy and hold?
Do you still think the goal should be to make as much money as possible? It should now be clear that risk aversion needs to be a very important part of your plan also. In fact, focusing on the end result is totally backwards. The prudent investor will determine what bankroll they need to arrive at in order to fund their financial independence life style choices. This will start by those ultimate choices. It costs more to live in a penthouse or mansion on Park Avenue, NYC, than rent an apartment in Spain for instance. Each lifestyle choice adds or decreases the ultimate nest egg you need for your bankroll.
Once you have determined your ultimate nest egg for financial independence, you need to define your time horizon you want to target to reach that goal. The longer time available, the lower yield rate you will need to get there. Shorter time requires higher yield to grow the same start to the goal.
Starting funds, time, and yield rate are the variables to reach the defined goal. Knowing the goal and your available starting funds, you can then find the yield rate needed to reach the goal in a given time and use the miracle of compound earnings to make the trip.
Now, we are at the next ingredient to prudent risk management. Higher yield generally only comes with higher risk. The balance of risk and yield is akin to an arbitrage. Excessive risk adjusted yield is quickly bid up (with yield then driven down) until a balance of risk and reward is achieved. Mathematically Yield = Return/Cost. Most financial analyses discuss yield on an annual basis. Dividends, interest rates, portfolio returns, all of these typically are discussed on annual rate or return (or yield). So, your starting goal and ultimate target nest egg along with the time horizon all combine to compute an annualized yield rate you must target to reach your goal. Since risk and yield are inversely related, targeting a higher yield than needed adds unneeded risk to your plan.
Now it should be clear that a wise investment plan should pick the path of least risk (lowest yield) to achieve the target goal in the time available. This is opposite of most typical retail investors, who spend their time chasing maximum yield, blind to the unneeded added risk they have taken that works against success in reaching their goal.
If your child needs a $1 million operation within a month to save his life, you may need to accept very high risks. However, it would be crazy to take the added risk to try for $2 million in such a case. The same is true of your goal to financial independence. Pick the path of least risk to reach your goal, avoiding any added risk even if it can bring added unneeded gain if successful.
No wonder so many retail investors conclude that investing is a gamble and they simple surrender to risk in hopes of hitting a home run before they go broke.
Gambling is a zero-sum gain with the odds locked in to the house advantage. For every winner, there must be a loser. The house makes the game rules so that the resulting statistical balance between random chance odds and payouts ensures the house a net gain of winds so long as they have a high enough sample rate (number of total bets placed). On any given bet they may lose, but cumulatively, the statistics ensure that they will make a net gain more than the losses so long as there is enough total play.
Stock markets on the other hand are not a zero-sum game. History and the principle of an expanding population and spendable income show that over the long haul, markets will always ultimately rise. For any given single ticker or time segment, this may not be true, but with a broad selection of quality tickers and enough time, gains are statistically assured. Like the casino, a well risk-managed portfolio is a business, not a gamble.
Success in making investment a business instead of a gamble requires:
- Clearly defined starting bankroll and target nest-egg goal for financial independence.
- A time frame sufficient to grow at a yield rate with 100% statistical probability of reaching the goal in the target time (see the J.D. Roth Chart above).
- Sufficient diversity of tickers to correlate well with the S&P 500 historical performance record. (Use of the SPY index ETF or other broad market index ETFs is one simple vehicle for this).
- A moat of secure income and savings to fund needed expenses to weather a downturn of up to 5 years so as to avoid forced liquidation in down markets.
In my next installment, I will discuss how to put these principles to use in building an actual investment plan and strategy for you to meet your goals by actual market investments consistent with your plan.
Thanks for taking the time to read my work. Please share your comments and join further discussion of this thesis in the comment section. I consider that section an integral part of the article, providing important added discussion from both readers and myself.
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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours. 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.
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