Risk when markets are down

Field of play

Without risk there is no progress

A representative of a savings-and-loan company came to Benjamin Graham with several questions.

“The first question he asked me was “Don’t you think that common stocks are now are less safe than before because of the decline in the market?” That hit me between the eyes. Here were financial people who could seriously consider that stocks less safe because they have declined in price than they were after they had advanced in price. “ (Graham, 1973 The Intelligent Investor, fourth revised edition.) p.10

The point very simply is that stocks in general and any given stock are no more risky when priced as bargains, and probably less risky. I ask the reader to ponder whether stocks were more or less risky in January 2009 at the depths of the Financial Crisis bear market? The answer is that they were less risky. There were some extraordinary bargains available at that time. I bought shares in a mining company at that time for less that the cash held by the company. The productive mines were thrown in for free. Investors were scared that the company would spend the cash on some bad project.

Ben Graham’s observation holds true today as it did in March of 2020 and January of 2009.

Insights of the greats

It has been argued that seeking better returns by buying value is associated with higher risk because higher value appears in risky economic times. Such simplistic thinking ignores the insights of Benjamin Graham, Warren Buffett, John Templeton and Philip Fisher about buying with a margin of safety and buying at a time of maximum pessimism. These investing greats are correct because they demonstrated that their approach works in the real world.

Risk and psychology

Our perception of risk is distorted by psychological factors. For example recent events loom larger than those that have faded with time – think war in Ukraine. Distant risks seem less threatening than immediate ones – think global warming. Risks that experts don’t seem to understand are more worrisome – pandemic risks in 2020. Risks of events over which we have little control seem more disturbing – think inflation. Understanding these distortions will help an investor to not only avoid the negative impacts but also take advantage of the psychological factors where the stock market seems distorted by them. I have written something like 25 posts about investment psychology. Here is a link to the introduction which contains links to all the others. One of those posts is : The psychology of risk . You might take a look..

What risks do investors face today?

The simple answer is that investors face the risks that the businesses they invest in face. What do I mean by this? I am currently invested in 13 companies. Inflation is a current concern in the business world. Inflation is a business risk. So the main question for me is how well each of the 13 companies will be able to deal with inflation risks. Supply chain problems are a business risk today. So, indirectly I face supply chain problems because the companies I invest in may face these problems.

What about interest rates and a possible recession? This is a bit more complex. To begin with, all the companies I invest in are extraordinarily financially strong. They are not exposed directly to a risk of interest rate increases. Their businesses may be indirectly affected. One of my largest holdings is in the financial sector. Its rate spreads improve with increased rates, so it benefits. Since it is not a consumer or mortgage lender it is not exposed to the weaknesses in those areas that might result from a recession. Really, each company case is different. I can look at each company’s business and assess whether there is a really significant risk from a recession.  

In this context – what does risk mean?

Some say that investing is all about avoiding mistakes; that one should work to avoid losses. Such an attitude is based on a philosophy that investing is centered on risk control through reducing portfolio volatility, dynamic asset allocation or heavy doses of bonds or high-dividend stocks. I disagree. In a common stock program, risk is relatively easy to control through stock selection, balance and diversification. My investment approach is not centered on conventional risk control.

Most individual investors seem mesmerized by risk. They want good returns but they want to avoid risk. I think risk is one of the most misunderstood concepts in investing.

Conclusion

Investing is inherently risky. One cannot bury one’s head in the sand when it comes to risk. One has to face it squarely. Without risk there is no progress, no advance and no success.

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Readers wishing to dig into some of the different corners of the world of risk might take a look at the Motherlode Chapter 4. Risk and Uncertainty

That chapter contains the following Sections:

4.01 Value Risk

4.02 Price Impact

4.03 Business Risks

4.04 Interest rate risk

4.05 Inflation risk

4.06 Currency risk

4.07 Liquidity risk

4.08 Idiosyncratic risk

4.09 Catastrophic risk

4.10 Fat tail risk

4.11 Systemic risk

4.12 A 1 in 1,000 chance of permanent loss

4.13 Uncertainty

4.14 Risk/reward trade-off assumption

4.15 Equity risk premium

4.16 Are higher rewards from lower risk possible?

4.17 Risks when markets are down

4.18 Risks when markets are up

4.19 Risk on and risk off

4.20 Conclusion regarding risk and uncertainty

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Other posts on investment psychology

This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction. This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.

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You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith

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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.

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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.

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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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