New Investment Advice » Investment Risk

Capital Risk Investment-Do They Fit Your Investing Objectives

admin — Mon, 29 Mar 2010 04:08:29 +0000

Historically, if we wanted to match or beat inflation risk over the long term we would have had to invest in equities. However, with equities, unless a fund offers a guarantee (and these can be costly), the individual’s capital certainly is at risk.

Diversification in mutual fund and within a portfolio in order to reduce risk at the total portfolio level. However, it is also important to be able to recognize the level of risk inherent in a financial product and this is not always apparent. Most of the major mis-selling scandals in the commecial financial services markets are a result of naivety and misunderstanding on the part of ETF investors, and the disingenuous desire to mislead on the part of providers and advisers.

The following benchmarks take a very broad-brush approach to investment, which provides a useful starting point to the assessment of an asset allocation class, product or scheme. It does not matter whether we are examining deposit investment accounts, collective best funds to invest, direct equity and bond investments or higher risk investments such as venture capital trusts, which invest in the shares of unquoted trading companies – measuring risk against certain benchmarks helps to keep a good overall perspective.

The benchmarks will also help students to focus on the important fundamentals as opposed to the ‘bells and whistles’, which are used so successfully in marketing literature to make products and services look more attractive, safer, tax break investment efficient or ethical than they really are.

- Aims: What are the stated aims and benefits of the investment? Do these fit in with the individual’s aims and objectives?

- Returns: Compare the potential net returns of the investment with after-tax returns on very low-risk products such as high-interest deposit accounts, short-term conventional gilts and National Savings & Investment low-risk products. Is the potential out-performance of the investment really worth the additional risk?

- Alternatives: Which other investments share similar characteristics? Are they simpler, cheaper or less risky?

- Investment period: For how long can the individual genuinely afford to invest the money? Compare this with the stated investment term and then check how the charges undermine returns in the early years. Check for any exit penalties and remember that a ‘loyalty bonus’ on an insurance product usually acts as a penalty in disguise if the individual does not continue the investment for the required period.

- Risk: What is the risk that the investment will not achieve either its own stated aims or the individual’s private objectives? What is the most he or she could lose? Is the capital and/or income stream at risk? What is the likely effect of inflation? How is the investment regulated? What happens if the firm investment manager defaults?

- Cost: Look at the establishment costs and ongoing charges. Remember that high annual management charges on collective funds, particularly for long-term investments, will seriously undermine the return. With direct equity portfolios watch out for the high transaction charges and turnover costs associated with ‘portfolio churning’ (unnecessary and excessive buying and selling to increase transaction charges).

- Tax: The way the fund and the investor are taxed is important because it will affect the ultimate return. Check for income and capital gains tax implications and consider how these might change over the investment period; for example if the individual retires and moves from a higher to a basic rate of taxation. As a general rule never invest purely for the sake of obtaining tax relief; investments must be appropriate for the individual’s circumstances and must be attractive with or without the tax breaks.

A Hidden Big Idea: How to Think About Risk When Investing

admin — Sat, 22 Aug 2009 02:11:47 +0000

Risk is a vital part of thinking about investing, even though you can’t put a number to it. You can’t really start applying many of the ideas in this book without having a good grounding in what makes a risky investment and what makes one investment more or less risky than another.

I think of the concept of risk in terms of enterprise value, cash flows, and asset values. Those three important concepts again. Most investors think about risk in terms of price. They buy a stock, and risk means the probability that the stock price will go down.

By this point, I hope you see that this is not a good conception of risk. You understand now that stock prices are judgments of value that you should not rely on. The public market quotations are going to change in ways that seem irrational. You need something else in which to anchor your concept of risk—and that’s your understanding of enterprise value, cash flows, and asset values.

So how should you think about risk?

First, you should understand that risk is more useful with an adjective in front of it — that is, as a specific kind of risk. For example, there are market risks and there are business risks. A market risk is the risk of the stock price moving against you in the short term. We don’t worry about this risk, which is the risk of unrealized losses or a reduction in unrealized profits. Market risk is a risk you should ignore.

What we are most interested in is the business risk — a specific risk to the particular business we are looking at. It might be the risk of a big customer leaving or the risk of losing a key contract. It might be the risk of a costly development project not panning out. Business risks can be lots of specific things. What we don’t want is a lot of risk that something bad will happen to the business itself.

The great risk we try very hard to avoid is the risk of permanent capital impairment. This is a fancy phrase that captures the idea of a business losing a material amount of money, suffering a severe drop in asset prices, or losing its credit standing. Basically, it is a real material loss that affects what the business can achieve in the long run. Permanent capital impairment shrinks the possibilities of what a business can achieve.

For example, suffering heavy losses that put the company in bankruptcy is an example of severe permanent capital impairment. Much will be lost to creditors — if not everything — and the stockholders’ interest in the company will be permanently impaired or lessened.

A less severe impairment may be technological obsolescence that has caused a significant piece of the company’s business to be worth much less than what was thought. Technology companies usually carry a good amount of this kind of risk that can have you waking up one day to find a competitor has passed you by or an industry has died. If you made typewriters, your business suffered a permanent impairment with the widespread adoption of the computer.

In mining, a permanent capital impairment may be the exhaustion of an important mine; a business in another industry may suffer the loss of a key asset when it is confiscated by a foreign government.

Corporate corruption can lead to permanent impairments. Fraudulent accounting, which leads to a huge write – down of assets, is permanent capital impairment.

We aim to avoid these risks as best we can. One easy way, as I’ve already pointed out, is to stick with companies with strong balance sheets and little debt. Without getting too much into accounting details, a strong balance sheet is one in which there is little debt, good liquidity (that is, some idle cash), and not a lot of funny assets — like goodwill (which we strip out in our analysis anyway).

As an aside, you should realize that your goal as an investor should not be to eliminate risk entirely. Every investment brings an element of risk. There is always something that can go wrong.

Even for insiders. There is a common misperception that insiders somehow have a free ride. The thinking is that their information is so good that they can’t go wrong. Hence, a number of services have grown up around the idea of following insiders. This can be a very good way to look for potential investments. However, you should realize that insiders face risk when they invest in stocks.

As an outsider, your risk is probably greater, but not always. I have seen insiders who believe so much in their own story that they are the last people to find out when it is no longer valid. They are like the proverbial captains who go down with their ship.

The main way I limit risk, both in what I recommend in Capital & Crisis and in my own investing, is to focus on the downside in my analysis. What we could make means nothing without having a sense of what we could lose and of the probability of experiencing such a loss. I’ m reminded a bit of a Charles Bukowski poem about one of his many visits to the local racetrack. He’s sitting there, drinking his beer and watching the horses but not betting. Finally, someone comes up to him and says: “You come here to win, don’t you? ”

Bukowski’s reply was: “I come here not to lose. ”In the same way, my focus in the stock market is on not losing. And the best way to do that is to pay a great deal of attention to the price I pay for an investment. In fact, I believe this kind of discipline is the most important part of any investment program. Here is an example of an investor who did a great job in covering his downside.

What is Your Acceptable Level of Risk in Investment?

admin — Fri, 17 Apr 2009 11:09:19 +0000

Your level of risk tolerance is the most fundamental thing in choosing the right investments for you. Before anything else, it must be understood that investing are like other things in the world: there should be positive and negative side to it. All investments follow 3 common principles. First, every investment takes with it a some of inherent risk. Second, risk and returns can not be separated such that the general principle of higher risk-higher return and lesser return, greater safety is widely accepted. Third, investing in anything for which one has no knowledge of is the kiss of death for the money invested.

With that being said, questions like what kind of risk tolerance investors are you are much dependent on many factors. These factors range from the personally acceptable risk threshold to the professionally proven investment risks.

Acceptable Risk Threshold

In risk management investment, risk is a matter of personal preferences. What is extremely risky for a new entrepreneur will be highly acceptable to the established entrepreneur simply because the personal circumstances with which risk is perceived are different between them?

So, when someone asking you question like what is your acceptable level of risk in investment in the quest to become a millionaire, there are four basic investment goals that will determine the acceptable level of risk to the individual:

- Income: Investments are purchased for the potential passive income that will come regularly. The principal can either be diminished or increased in the process, which is good either way.

- Growth: For this factor long-term appreciation in the market value is sought much more than principal safe and regular passive income flow.

- Speculation: For individuals with high tolerance for losses, speculation leaves for either higher and faster returns or quicker but larger losses.

- Safety: There is minimum risk of loss such that the principal can be returned almost full. This is very conservative albeit very safe; this is suitable for person with low risk profile.

When making investments decisions, individuals will do well to define the category of investors to which they belong to. By doing such things, proper risk-taking measures like gathering information about the desired investments and balancing the risks and return based on the information can be performed.

Likewise, it pays to plan the exit strategy before actually having the investment. Like mentioned previously, by nature investments have the risk of success and failure, which basically means that there must be a safety net when the latter happens!

High-Risk Schemes and Scams
Before you dive into investing, make yourself well informed about the situation, it also pays to do research on the various scams and schemes that will make questions like what are the risky factors or it is completely superfluous. After all, these investment schemes have been the end of the road for some newbie investors like you!

You may heard of Madoff with his Ponzi schemes investment, pyramid schemes (think of multi-level marketing online companies) and boiler rooms (it is the method being used by telemarketers to get your money to join them).

Nevertheless, the most important thing you can do to protect money invested in anything is to know yourself. Remember that investments are meant to make you relatively happy, now and in the future. Don’t forget what Warren Buffet words of wisdom in investing, if you are not comfortable carrying on to something for 10 minutes, you will not be comfortable sticking to it for the next 10 years.

So, how is your acceptable level of risk in investment? It depends on what risks you are willing to take to secure desired returns, one of which is to become a millionaire quick.