Investment risk rarely matches the risk perception in a security. Let’s see why.
Held long enough, the price of a security approximates its value.
- Buying overvalued stocks in most cases deliver lackluster performance as the value struggles to catch up with the price. The price may decline, or if the business is growing value at a rapid pace, than perhaps there may be some price appreciation. Regardless, there is a better way to invest with less risk and more rewards
- Buying undervalued stocks, in most cases deliver outstanding performance over time as the price rises to catch up with the value – as long as the business continues to create value over time
The critical phrase here is “held long enough”. We will discuss “risk” with this as a backdrop. For investors who are essentially short term investors, looking for a quick profit, the value in the business does not matter much. When investing is not based on the underlying business fundamentals, it quickly becomes speculation. And speculation is notoriously hard way to create long term wealth on any sustained basis.
So What is Risk?
Quite simply, risk is the possibility that the investment does not work out well. In some cases, you might have to wait longer than expected for the value to be realized. In other cases, you may even experience a loss of capital. Investment risk is essentially the downside risk of the security over your holding period.
This can happen for a number of reasons:
- You make a mistake in building the investment thesis for the stock – Value investing is more art than science. Mistakes can happen. You might over estimate the value of an asset, or under estimate the level of distress on the business. Or you just might have a misplaced decimal point in your spreadsheet. While it is essential to be as thorough as possible during the due diligence period, and lean on the conservative side, it is fool hardy to believe that the possibility of a mistake does not exist.
- The market continues to stay irrational on the security – Ever buy a stock that you think is a terrific value, and two years later, the stock is still a terrific value? I have. Although the stock has returned a quite respectable gain in these 2 years, the undervaluation persists. Some of the other stocks may be even less fortunate and the price might barely budge for years, even as the company fundamentals continue to improve.
- Future may turn out to be different when you reach there – Value investors try to protect against the uncertain future by paying more attention to the assets and asset quality and less credence to the earnings projections. There are still other ways your investment thesis may trip up. Economic conditions may change. Competition may intensify. FDA approvals may be withheld. Management may turn out to be corrupt.
How do you Protect Against these Risks?
The simplest way to protect against the risks that you may not even know exist, is to demand a healthy discount to value of the security you are buying. Also called “margin of safety”, a typical 30%-40% discount to the intrinsic value is a good protection against unknowns and your own mistakes in your analysis. In cases where the business has significant risks that are KNOWN, it may still be a terrific investment if you can buy the stock at a greater margin of safety. There are very few sure things in investing and the goal is to maximize your returns adjusted for risk. Sometimes, you may have to take some calculated risks when the potential rewards justify it. To protect your downside, a margin of safety approaching 80% or more may be required
All this assumes that you are researching and analyzing the business of the company and its fundamentals before you make the buy decision. Not knowing the business you are investing in exposes you to another type of risk. The stock may indeed be a great investment, but you may not be able to realize the profits if you miss the red flags that might appear in the future.
Risk is Not the Same as Volatility
If you have done your homework on your stock picks and are very confident in your research, and the company continues to execute in a way that affirms your thesis, why should you care if the stock price continues to go up or down on a daily basis. Daily stock fluctuations merely reflect the daily demand and supply of the shares, which for small cap stocks that are less liquid may be extreme. Have the patience to wait for the market to catch up with the value, which it will over time.
That being said, volatility does create opportunities to increase your stake in the company. If the business is truly undervalued, any opportunity to increase ownership should be welcome.
On the flip side, it is quite possible that a stock may hit your valuation target on a short term upswing. In cases like this, there is no reason to not liquidate your position if you can. Taking profits early is always better. You can redeploy your capital in other more undervalued assets. I always go in a new investment with a target sell price and put in a GTC limit order to sell at that price. Sometimes, I may revise the target price up or down depending on how the company performs in the future. This is not the same as a short term speculation strategy. The difference is that you know what you are doing.
A disciplined buy and sell strategy and the commitment to stick with it is essential to manage your risk. It is altogether too easy to get carried away with “momentum” and “hype” when the stock price is on the rise. Emotions and sentiments should play no role in your investing.
With this being said, you should get in the habit of reading Wall Street’s reports and ignoring their recommendations. More on this later!