Understand risk before investing

Markets are volatile, sometimes violently so, but the second most important thing to understand in investing is that volatility is not the same thing as risk.

And understanding the difference is important. As I stated last week, to succeed in investing over your lifetime, you need (i) a business-like plan; (ii) avoid being unnerved by volatility; and (iii) have the patience to let compounding work its magic over time.

So if volatility is not risk then how do we define risk? In physical property investing, we might define the three major areas of risk as location risk, debt risk and valuation risk. Buying a property in a poor location or in a geographic region where the rule of law is not sound are location risks. Adding too much debt to a property transaction is risk, as you may not have a sufficient margin of safety built in if property prices drop. Judging the value or otherwise on offer in physical property – using the rental yield – is a good deal easier than in equities.

In isolation, buying at an overvalued price is not lethal. But buying property at an overvalued level with debt is lethal.

In Ireland, whether we were buying property in Ireland or Britain between 2002 and 2006 with debt, we were taking on both debt and valuation risk.

Anyone who got on a plane to the far flung areas of eastern Europe was also taking on location risk.

Stock market risk

Risk in equities can be largely defined in the same terms. There is business risk – the risk that the business you buy will not be generating the same level of earnings in five or 10 years that it is today.

Earnings at companies can drop permanently over time for many reasons – disruptive new technologies, new competitors entering the industry or new regulations to name but a few.

In Ireland, we have had many examples of this. Changes in consumer lifestyles and purchasing habits permanently reduced demand for Waterford Wedgwood’s products over a period of time. The advent of the internet has spawned a new low-cost, online stockbroking model that will continue to weigh on traditional private client stockbroking services.

The proliferation of iPhones and now iPads and the generic alternatives is changing the publishing and music industries, to name but a few.

Buying into a business where profits are eroded subsequently can lead to a permanent loss of capital.

The list, above right, highlights the stocks quoted on the Irish Stock Exchange in 1970. Just a few remain today. Business changes over time which introduces risk.

Financial risk is the use of too much debt at the company level and it can lead to a similar permanent loss of capital.

This, of course, is what the banks got wrong, and not just in Ireland. They took on too much debt and lent it out badly. So simple, in hindsight, to see the issue.

Focus on value

The value you obtain when you buy a business – be that a private or publicly quoted business – is also important. Paying too high a price relative to the business’s sustainable earnings, cash flows, dividends or assets can expose the investor to a permanent loss of capital.

In my book 3 Steps to Investment Success, I use the Coca Cola example to drive home the point. In 1998, Coca Cola earned $0.70 a share and its share price reached a high that year of $43.50. Today, some 14 years later, Coca Cola’s share price remains 15 per cent below its 1998 level. Yet, today, investors expect Coca Cola to earn $2.05 a share. Despite having grown earnings at a respectable 8 per cent compound per annum since 1998, Coca Cola’s share price has backtracked.

The problem, of course, was that Coca Cola’s shares were grossly overvalued in late 1998 and, despite management’s success at generating continued above-inflation earnings growth since, the initial overvaluation could not be overcome even over a 14-year period. Some might describe that as a near permanent loss.

Volatility is not risk

In my view, most private investors are not equipped to deal with the three risks as outlined above, and, as I mentioned last week, should consider investing through funds.

Nowhere in the above discussion of risk does the word volatility appear. Quite simply, volatility is not risk. The markets are volatile, and they always will be: it is the nature of the beast.

There are a few identifiable reasons why markets are so volatile. The economy is volatile and experiences periods of contraction as well as expansion. A contraction in the economy leads to lower revenues for business and, with fixed overheads, this, in turn, amplifies the reduction in corporate earnings. Furthermore, stock markets are emotional and over-react to these likely changes in business fundamentals.

The table, above left, highlights the four last economic recessions in the US and the peak-to-trough decline in economic output (GDP) during those recessions. Corporate earnings, as the table highlights, fell much more dramatically than output in each recession.

The amplification of the decline in corporate earnings explains a significant part of the volatility in markets.

Volatility is not risk and you need to understand this if your lifelong investment plan is not to be derailed when pressures mount. Any one of the three risks – business, financial or valuation – can expose an investor to a permanent loss. There is a world of difference between the threat of a permanent loss and the opportunities normally presented by temporary declines in prices (volatility).

If you cannot tell the difference, you risk turning temporary declines in prices into permanent losses at several stages along the stock market cycles.

In next week’s concluding article we will examine the time it takes to benefit from compounding and how any private investor can benefit from extra returns in passive value-focused funds.

Rory Gillen is the founder of Gillenmarkets.comand author of the recently published 3 Steps to Investment Success published by Oak Tree Press and priced at €19.95

Where are they now? Irish Stock Exchange listings in 1970 

(1) Allied Irish Banks

(2) Bank of Ireland

(3) Ryan Tourist Holdings

(4) Alliance Dublin Gas

(5) Clondalkin Paper

(6) Heiton Holdings

(7) Jefferson Smurfit

(8) Freedex

(9) May Roberts

(10) Silvermines

(11) Guinness

(12) United Distillers

(13) Credit Finance

(14) Bolands

(15) Ferrier Pollock

(16) Arklow Pottery

(17) Braids

(18) Cahill

(19) PJ Carroll

(20) Cement Roadstone

(21) Central Hotel

(22) Gouldings

(23) Irish Dunlop

(24) Irish Ropes

(25) Irish Shell

(26) Metal Products (Cork)

(27) Williams (H)

Only those companies highlighted in bold are still listed on the Irish Stock Exchange