Stock Investing - The Risks

As with anything else in life, there are always risks associated with stock investing. In the case of stock investing, the risks are different than in the case of real estate investing, or investing in your own business. One might also invest in art, hobbies, timber, land, cars, coins, and just about anything else you can think of. Our focus today is on STOCK INVESTING, so lets begin with the risks:

Stock Investing  Risk # 1  Timing

They say in life that timing is everything and yes, this is absolutely true in stock investing also, but in stock investing, there are times when you dont get to choose the timing. One of the things we do is monitor the buying, and selling habits of the wealthiest most informed corporate executives in America. Who knows a company better than its Chairman or CEO? If the Chairman is a buyer, it tells us something. If hes a seller, that tells us something too.

We have noticed one thing through the years about stock investing. If a CEO or any smart individual is buying, its only for one reason. They want to make money. There is very rarely any other reason to be involved with stock investing. The opposite is not always true however. If a person is a seller, you never really know why that person is a seller. They could tell you anything they want, but the truth may not be known.

It could be that the investor is selling to pay taxes, to finance another business, to pay for a wedding, or to pay for some other obligation. You simply dont know. Now with stock investing, what does this mean for us? It means if you possibly can, you want to be the one to determine the TIMING of your buys and sells. If you get to pick the timing, than you wont be forced to sell into a declining market. You wont have to sell when it looks like the world is coming to an end. You will be able to sell when everything looks rosy, and thats what you want to do.

Stock Investing  Risk # 2  Interest Rates

Another risk in stock investing is the INTEREST RATE RISK. You and I have no control over interest rates because they are basically determined by the interaction of everything that is going on in a nations economy, and the world economy also as it interacts with a nation. Most of the time, it would be a true statement to say that the nations banks set interest rates.

In reality, those rates are set by the Federal Reserve Board, whose Chairman is selected by the President of the United States, and is confirmed by the Senate. As a member of the Federal Reserve Board, Ben Bernanke (the Chairman) was appointed to a 14 year term. As Chairman he has a four year term, which will expire in 2010.

The Chairman, Ben Bernanke has tremendous influence over the direction of interest rates in his position. The Central Bank is really the primary determinant of which direction interest rates are going to go in. If you want to know which way rates are going, watch the Fed and its actions. There are a whole group of people in this country including economists who call themselves Fed Watchers.

Interest rates have tremendous influence on the stock market. There is an old saying that goes, You cant finance a bull market on expensive money. Generally speaking if interest rates are headed upwards, the stock market and stock investing does not do so well. If rates are headed downwards, you generally have an ascending market. These are all relative statements, and there are all kinds of exceptions throughout history. As a general rule, they are true however.

Another issue that involves interest rates and the stock market is the decision as to whether to invest in stocks or bonds. Some times these two vehicles are at odds with one another. Lets say you have a bond yielding 3%, and you think that a stock you like can go up at an average of 12% to 15% per year for the next couple of years. Now we know there are always individual stock risks with any security you might be thinking of investing in, but lets leave that aside for a moment.

The 3% yield on bonds, may not strike you as much of an investment, compared to the potential gain of 15% on a stock. If rates were higher, and the bond was yielding 9% or 10%, you might say to yourself, Who needs the risks of a stock with everything thats involved if I can get 10% on my money in bonds. This is how investors think, and weigh out in their decision making process.

Generally in a rising interest rate environment, bonds will fall in price. This is because the face value of a bond always remains the same, which is usually a thousand dollars, and they are sold in thousand dollar increments. In order to equalize the various factors that are involved with bonds, the bonds themselves go up and down in value as interest rates rise and fall. In a falling environment, a $1000 bond might sell for $1200. In a rising interest rate environment, the same bond might sell for $800. You need to know this if you are going to be involved with stock investing.

Stock Investing  Risk # 3  Financial Risk

In stock investing, the financial risk is crucial and unique to each individual stock. The financial risk is the risk to the company itself that you are investing in. In other words, if the company does well, you will do well, and therefore, you would have encountered very little financial risk. If the company does poorly, and the stock does poorly, than your financial risk proved to be great, and your investment was a poor investment as well.

You attempt to lessen your financial risk in stock investing, by using what we call research. You get to know as much as you possibly can about a company and the environment in which it is operating. You study the balance sheet, the income statement, the statement of cash flows. You read the annual report. You read stories about the companies including the news that is reported daily, and maybe the footnotes in the annual report, if you are really on top of the game.

You might study the competitors. You might go to stores that sell their products and talk with people that sell their products and see what they think. You do everything that you possibly can to lessen the financial risk involved with stock investing. Some of this is just plain common sense, and sometimes investors do not exercise their minds when it comes to common sense.

Now remember, with stock investing, you could do everything right, and still get everything wrong. You might be right on the company, and the stock, but wrong on the economy, and the economy could go the wrong way on you, and you might see a very poor investment as a result.

You could be right on everything else, and still be wrong, because you might be wrong on the valuation of the company you are an investor in. It might be that the valuation is too great, as it was for hundreds of Internet companies in the year 2000, when the market went against them. All in all though, you are much better off being aware of the financial risk in stock investing when you do invest, and attempt to lessen it to the extent that you can.

Stock Investing  Risk # 4  Inflation Risk

Inflation is very simply when you pay more money for the same goods and services. Lets say you buy a loaf of bread for a dollar. Five years from now, you buy the same loaf of bread, it tastes the same, looks the same, smells the same, but its $2  THATS INFLATION. This means inflation can also be called a generally upward price movement in an economy for goods and services. By definition if the same goods and services are costing more and more, for your money, this means the value of your dollars is going down. This is a crucial point.

Lets say you had a million dollars in the bank earning 3% per year. At the same time, lets say the average cost of goods and services in America were going up about 4% year after year. This means you would be losing purchasing power on your million dollars by holding onto cash year after year. This is what inflation really is. Its the crippling of purchasing power if you hold cash. Another way to look at this is to say that INFLATION RISK =s PURSCHASING POWER RISK.

Historically in our country, a period of high inflation is not good for stocks. This means that stocks tend to do poorly in a high inflationary environment. The converse is also true. In a low inflation environment, stocks tend to do better. If you are into stock investing, you would like to know what type of environment the next few years will hold in terms of inflation.

Stock Investing  Risk # 5  Market Risk

Market risk as it relates to stock investing deals with risk that has nothing to do with individual stock selection. When you purchase your stocks, the market will always be trading at a certain level, with a certain degree of optimism, and or pessimism present at any particular time.

Lets say you invest in a company today when the market is trading at 10,000 on the Dow. Tomorrow when you wake up, the news reports are telling you that oil pipelines in Saudi Arabia have been destroyed overnight, and 12 million barrels per day of oil have been taken off the market. The results are gasoline lines at the pump in the United States, and the oxygen being removed from our economy.

The Dow Jones opens 2000 points lower, that my friend is MARKET RISK. It is the risk associated with the market that you are investing in, completely independent of the stock itself that you are investing in.

Volatility is the name of the game in the stock market. Stocks go up and down in price. If you choose well, over time you will do well. We believe it is almost impossible to determine how you will do on a daily basis. We do not believe and we have not found anyone that can correctly predict daily fluctuations in the market place. If you think you have found that person, or a system that can do that, then we suggest you think again. It just doesnt exist.

You should be able to overcome volatility and MARKET RISK by investing for the long haul. Stock investing in long term situations should tend to wash out any short term volatility you may be encountering. Having studied 35 year charts, we can tell you this with certainty. Over a period of years, stock price follows earnings, and earnings follows stock price.

Stock Investing  Risk # 5  Personal Risk

You are doing well. You are making a lot of money with your company that you started and it is now mature. You own a home. Your children are doing well. You own your cars for cash. You have investments in real estate in your area that are leveraged, but not highly so. You feel good. You got a couple of million dollars in stocks.

Its now a month later, and you have just been informed that your company has lost its biggest contract with a company that you have been doing business with for a dozen years. Your clients business is moving to China, and you realize that your whole town is tied in with outsourcing to China. As a result the real estate values in your town start to go down in value.

Guess what, it doesnt matter how well your stocks and the general stock market is doing, you need to be a seller of stocks because you need to raise cash. Its that simple, and that my friends, is PERSONAL RISK. Its the risk that is personal to you in the stock market. You are forced out of the game.

How do you deal with personal risk in the market? You always need some cash laying around in a fund, or a bank account, or a checking account. It doesnt matter, but you do need it to be freely accessible. This is your SCREW YOU fund, or your RAINY DAY fund if you will. If you have such a fund, you will not have to liquidate stock investments, or any other type of investment, when adverse conditions hit you, if it happens.

Stock Investing  Risk # 6  Government (Political) Risk

This is not something we think about in the United States, but more and more of us are investing overseas in other countries. One of the problems with this approach is that if you are brought up in the United States, and use to stock investing in this country, you tend to put a US based template over the stock markets of other countries and treat it like you were investing in the US.

The world just doesnt work that way. America is a country with 300 million people. In 2000, George Bush won the Presidential election by perhaps a couple of hundred votes in the state of Florida. In most countries that election would have been settled with guns and bullets. In the United States it was settled by a group of judges (Supreme Court) making a decision that everybody abided by. This makes our country unique.

If you are involved with stock investing in overseas countries than you have to consider the political risks of leaders changing, parties changing, the very form of government changing while you are holding stocks in that country. New currency laws could outlaw your ability to get your money out of the country. Governments could nationalize the industries that you have invested in, and make a good portion of your investment, or all of it, disappear overnight.

In the United States, the government could pass laws dramatically changing the working environment that companies whose stocks you own are operating in, and thus decrease your portfolios values overnight. What if you owned a tobacco stock as an example, and tobacco became illegal next week. These are government, and political risks, be aware of it.

Stock Investing  Risk # 7  Emotional Risk

Wall Street is driven by FEAR & GREED, and GREED & FEAR. When a stock works out, you never own enough. When a stock does poorly and goes down in value, you always own too much. This is Wall Street, and welcome to stock investing.

When the market is roaring high, everybody and his brother wants to get in, and buy at the TOP, when emotions are pulling you in, telling you higher, higher, higher. When the market is tanking, and the same stocks are selling 30%, 40%, 50% cheaper, nobody wants to buy. Its FEAR all the way down. The same stocks that people were standing on line to buy at the top, are being given away at the bottom, and there are no buyers. This is the stock market, and this is stock investing, and this is also what we call EMOTIONAL RISK.

Your biggest concern with EMOTIONAL RISK is the tendency to throw all common sense out the window in a bull market, and withdraw inside a shell in a bear market. We know lots of people that in bear markets wont even open their monthly statements from their brokers.

You must learn to keep in mind that stocks show no emotions. They are DISPASSIONATE objects or pieces of paper. Never be involved with stock investing on the basis of EMOTION. It will kill you. It will blow up your stock portfolio. Stock investing is done on the basis of cool, calculated analysis. Yes, without question, all kinds of investors around you are caught up in the emotionality of investing. Dont let yourself be one of them.

Do your homework, and then do some more homework, before you start the process of stock investing. Read everything you can about the stocks you own, and get rid of OWNERS BIAS. This is a bias that forces you to give greater value to the good things you hear about a company, and less value to the bad things, only because you already own the stock.

One of my mentors who made a billion dollars in the stock market said to me one day, Stocks are like toilet paper, use them and treat them that way. Hes right, get rid of the emotions you may want to attach to stocks. Start thinking objectively and you will make a killing in the stock market. Its really up to you. Good luck, we hope you enjoyed our narrative on stock investing.

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Lewis Glucksman
Former Chairman, Lehman Brothers

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