Balancing some risks and rewards with investing

Balancing some risks and rewards with investing

I’ve been interested in the stock market ever since my grandpa asked me to help him choose and track some shares with him when I was just ten.  I’ve been hooked on reading and learning about the stock market ever since.

My first investment was in my second year of university in January 2010. I was studying economics at the time, and in particular, portfolio theory. I decided that I needed to actually take on some risk in order to better understand how to think.  I admit, back then, my investment thesis was poor.  My understanding was that a good investment was one other people were talking about; it made some profit and paid it some dividends.  While investing in dividend paying stocks (as Mark does) can be a sensible strategy I had mixed success.

Many of my initial investments did not pay off.  I was lucky enough to be heavily invested in bank stocks post the 2008-09 world financial crisis.  Within a year of that crisis ending, I was able to double my money on the bank stocks I owned and just about offset my losses on all other assets.  While a positive outcome I learned some valuable lessons.  I realized that my investing strategy had to change.

It had to be far more rigorous and technical. Rigorous learning began.

My current investment strategy

Fast forward from the financial crisis and my investing knowledge has grown, significantly.  I have long since finished my degree and my accountancy qualifications.  I’m now working in financial modeling in London, England.  I fully appreciate many of the keys to investing success.  One of my favourites is determining value.

The great investor Warren Buffett once said that “price is what you pay, value is what you get”. On paper this idea seems simple: calculate the intrinsic value of a company, if the current market value is significantly below the intrinsic value then you can invest.  But what is value and how do you calculate it?

Intrinsic value – to manage risk

To discover the intrinsic value of a business you need to estimate the cash the business will produce in the future.  In general terms, intrinsic value is the actual value of a company (or an asset) based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.

Consider the fact a business produces X amount of cash today.  This may or may not be the same value produced many years from now.   Intrinsic value calculations should be fairly intuitive to many investors.  Due to the eroding effects of inflation and taking money from the business today, that’s a far less risky proposition than forecasting what might happen in the unknown future.

Since evaluating my stocks in some way, for the assets I hold and also might want to hold, I now ignore all investment tips and suggestions.  Instead I focus on what stocks appear to have intrinsic value. This technique has served me well.  To date, I’m ahead of the market.

Investment risks and what to do about them

My methodologies aside, this brings me back to the punch line for you and what Mark said I could help you out with:

When it comes to investing there’s always increased risk involved with greater potential return.  Consider it the cost of speculation especially if you are wrong!

Your investment risk can be reduced by diversifying your assets across your portfolio.  On the equity side, I strive to own a range of companies in different industries.  This way, for example, if the retail industry is struggling my energy shares won’t be affected as much.

I also always caution (myself) not to over-diversify.  I think it can happen!  Many investors think that owning dozens of companies diversifies their equity risk.  Not automatically so.  There are a couple of issues I see with that approach:

• You can actually diversify too much. That means you diversify away your profits as well.  While a particular stock may double in value, depending upon how much of it you own, it can have a very small impact on your portfolio.
• Through random individual stock purchases striving for more diversification you could be wasting money via transaction costs. If you’re not prepared to diversify across companies, industries and countries – why not just buy an index fund?!  (Check out Mark’s link on Indexing here.)  That will spread your investment risk across hundreds or thousands of stocks for a low fee.
• The other issue I see, related to my point above, how can you possibly ensure you understand every company thoroughly in your portfolio? Do you have the ability (and time) to track dozens of companies at once?  The answer is, for most investors, you probably don’t.

Balancing risks and rewards

Whether you save and invest in Canada like Mark does or in London, England like I do, at the end of the day you (as an investor) need to determine what your financial plan is.  This includes what investment risks you’re willing to take on for any long-term potential rewards.

Individual stock investors might be taking on more investment risk than they are willing to believe.  This means when it comes to my portfolio, I have methodologies in place to help me manage my risk appetite.  I encourage you to find your own balancing act of risks and reward.  It’s a critical part of investing success.

Mr. Moneybanks lives in London, England and is a fan of My Own Advisor. He writes on his blog at MultimillionaireRoad.com, sharing his ideas about wealth. Join him on his road to riches.