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Some notes on safety and risk in investing.

I really do know what risk is. I have travelled across a minefield, not once, but twice. First, when crossing the border between Algeria and Morocco during their short war back in the sixties, and second when crossing into Ethiopia from Kassala in the Sudan.

On neither occasion did I take any risk. In Morocco I was given a map at the border and told to always keep to the left where there was any doubt about the route. In the Sudan I went over by deportees bus.

Each situation was in itself risky, but on each occasion there was a big element in my favour: information. I knew where the clear route was.

I use a different example to show generalities about this kind of situation. It's dangerous to lurch at speed round a corner on a dodgy road. But if you know there are serious pot holes in the road, then you can slow down and watch for them.

I put this another way in my book on property investing. It's the bad news that is the most important. You find that out first.

If you follow the rules above, and get proper information, then risk can be minimised.

If you invest in various financial instruments, one of the first things you do is control your risk. You do that by following rules that have been found to have a high probability of success. Naturally, you start on the assumption that there is no such thing as 100% certainty.

Let's take this first. You dont know you will get up tomorrow morning. You assume you will, but you could have a heart attack in the night and not wake up. You could drive into town and some idiot comes round the corner on the wrong side of the road and wipes you out. You could go out in the morning in a temper, slam the front door, dislodge a slate that crashes down and slices a hole in your head.

There is risk at every step. In most instances we learn to manage it, in others we completely ignore it. Professional traders manage it.

Okay, so let's cut to the world of probability, namely, that although there is no such thing as certainty, we can reduce risk considerably.

The world runs on probability. It is geared that way. That's why there is what is called massive redundancy built into the system. All elements of an ecosystem will not survive, but the group has a high probability of survival. All of quantum physics is based around the concept of quanta, or arrays of data, and the outcomes are predictable in terms of the probability of the motions of the arrays, not the individual instance within that array. In short, I dont know which bottle on the assembly line will break, but I know that over a period of time x numbers will break, and my costings and pricing are based on that known probability, which is itself based upon an unknown (which bottles will break). All life functions this way. Risk management is a way of dealing with these parameters.

Let's move on to some financial examples. If I put £10,000 into a deposit account at the bank and receive 2% interest, then I am managing risk in a negative way. Let's see how the deal pans out.

Putting money on deposit in the bank represents a small risk, but a very definite one. It is a risk that has increased dramatically in the last year due to various inter-government agreements that deposits are now legally regarded as fair game for the bank to turn into capital assets (theft). I have written an article on just this topic. You should check it out.

You manage your risk by assuming that the bank will not distrain upon your deposit and turn it into bank capital. That is a risk you presumably accept, but it is a risk nonetheless. You also accept the certainty that you will lose money. That is why I call it negative risk management. Currently in the UK inflation runs at about 3%. If you are getting 2% on your deposit you are guaranteeing a loss. Risk has been turned into a certainty, but that certainty is that you lose money. What kind of risk management is that, where you guarantee to lose?

Let us say you invest in real estate and rent it out. There are several risk factors you have to look at. The main ones are concerned with the quality of your tenant. What is the risk of your tenant not paying the rent, wrecking the happy home, filling the place with drug dealers and annoying the neighbours? What are the other risks? Repairs and renewals are not easily quantifiable. You have to make assumptions. In other words you take on risk. Suppose the market slows, and you cant get a new tenant, and end up with a long void? All these items are real risks. How do you manage them?

The easy answer is that you resort to probabilities yet again. It is the only way. You measure the probabilities of each disaster against past examples, and current situations. Is the rental market buoyant? Is the area one of high employment? Is your house new, and not in immediate need of repair? Have you done a credit check on your tenants, and so on?

You then look at the reward, and balance the risk against the reward, and make a decision.

Some of the things people forget to factor in mean that most people make mathematically absurd decisions. The most common element people forget is opportunity cost. I bang on about this rather a lot. Simply put, if you buy a house with cash, you have the house but no cash. You should always do the risk/reward sum before you do the deal.

Risk? Oh yes, big risk. Read on.

You have £200,000. You spend it on a house, you now dont have £200,000. If you'd had the £200,000 you could invest it and get a return of £20,000 a year. If you didn't buy the house could you rent it for less than £20,000 a year? Now you have a risk/reward sum to do. (And I am getting rather tired of people telling me they cant get a 10% return on their investments. I'll come back to that later.)

First let's look at investments in stocks and financial instruments. First you look for good returns. The higher the better. Those of you who have followed my work for years will know I talk about various investments. I am invested in bamboo in Nicaragua. (You may have seen a program on the scheme on tv.) It currently returns only 6%, but that rises over the years to average 18%. I invest in certain stocks, one of which gives a perfect example of how to manage risk.

First, you need to understand about stocks. Buffett states that he loves pessimism because it pushes down the price of stocks so he can buy them cheaply. He loves it when stocks go down. Those who dont understand the elements of investing dont get this. They like stocks to go up.

Buffett also says that he does not buy a company for $1 million this year and look to sell it for $1.2 million next year. He buys the stock because he likes the company, and the dividend, and of course, he holds for decades, and gets the value of compounding.

Let's go back to a stock I bought in 2009. It is called Annaly (NLY). I bought it because it has a very good business. It borrows money off the American government at a very low rate, invests in real estate that is then leased back to government offices, and collects the difference. While interest rates are low the business is very profitable; when interest rates rise it is less profitable.

Note, we have a risk here, that interest rates will rise. Who cares? We know the risk. We can act accordingly. In short we can manage it. Interest rates moved up slightly two months ago. Annaly's stock price reacted as expected. But, who cares? Are we looking to sell? Is there a real risk?

If you bought when prices were high then you are in trouble. If you bought when pessimism was everywhere, then you are laughing. I bought at $9. The price moved up to $17. Very nice. I've doubled my money and can sell. Great, except I would only do that if I knew somewhere else where I could get more than 17% returns. I decided to hold and keep getting the dividend. I can afford to hold until the price drops all the way down to $10. At that price my capital gain is still over 10%, but I'm not interested in a mouldy 10%, I bought for the dividend.

Let me stop there for a moment and bring in another point.

If I trade the FOOTSIE or the Dax, or some other financial index I first of all look at the probabilities of the trade. If the probabilities give me a 50/50 chance of success, I know I will make money if I manage my risk carefully. Please let's get this clear. I can make money if I am wrong 50% of the time if I manage risk properly. Most people simply dont understand that. I give a carefully worked out example of how that works in one of my issues of The Big Pension. It shows how to make money if every second deal you do goes to nothing. I therefore operate carefully thought out stops. They protect me from large losses, but allow large profits to run. My risk allows small losses, but large profits. On a 50/50 success rate I will make money. The risk of losing money is negligible. This means I have managed risk, and can proceed satisfactorily.

I dont do that, however, I use systems that are currently producing successes at the rate of between 70% and 85%. The maths are simple. Over a period of time I cannot lose money. My risk of making a loss over any period of time in excess of a month is far less than the risk of being run over if I do some jay-walking. It's as close to zero as one could reasonably expect. Most people cant see this, and if you are one of those, I cant help you, but can only suggest you go see a maths teacher.

What I will do when I enter a trade is to place a stop, and also I will make my trade risk free as soon as possible. I can do that by placing a stop at entry once the trade is in profit. Whatever happens after that my trade is risk free.

Now let's go back to NLY. I bought in 2009. At that time the dividend was 17%. Four years later I have received a total 68% in dividends. In fact, because of compounding, that return is much higher. In one more year my investment will be risk free because I will have come within a whisker of getting all my original investment back in interest. Everything after that is in for nothing. Risk = zero. Even if the stock price halves I can still get out at break even so I lose nothing. If I decide to stay in, I know the stock will not go to zero, and I am likely to still receive my dividends.

What will make me sell? If the stock breaks $9, or if interest rates rise enough to threaten the dividend. When that happens, and it will, I will move onto another deal. My risk is zero, nothing, sweat FA, because I know the problems, and have a plan to deal with them. Just as important, I cant lose money. If the stock went to zero over the next two years I would still be ahead. It just isn't possible to lose.

Now, who has the risk free investment, the person with money in a bank deposit account, or the person who bought a stock which is currently falling?

Let me ask you another question. When I was 16 a friend of ours, Sir John Templeton, tried to explain to me the principles of investment. Upon his advice I put £1,000 into CocaCola. By the time I was thirty my initial investment had quadrupled, but, more to the point, my ROI (although small) was over 30%. If I still held that stock the dividend now would be about 400%. Would it have mattered if the stock fell through the floor at some point?

The answer is 'no'. It has fallen through the floor several times. It has not made one jot of difference to the constant increase in the dividend.

"When you buy a stock you buy a business" (Buffet). If it's a good business, why worry what other people will pay for it? (the stock price). You profit by their pessimism, and back up the truck. And the more crashes there are the safer your investment because you can get in again in a good business where you got in five six or seven years ago. How nice. And your existing dividend payouts have given you a nice return in the interim, and will carry on covering your position. And after ten years you are probably in for nothing. Your risk goes from negligible to zero.

Dont go out and buy CocoCola, or Johnson and Johnson. Wait for the next crash, and then load up on all those great continuing businesses. You wont regret it. The following people are a proof that this system works a dream. Templeton, Soros, Buffet, Rogers, Tudor Jones, and so on. Or do you think all these mega-millionaires, and billionaires are idiots?

For the record, I am looking back at one of my previous issues and see back in the old days I recommended Coca Cola in 1992 when the dividend was 8.42%. £10,000 invested then would now be worth £52,000 irrespective of two massive crashes since that time. I believe the dividend has risen every year since then.

The secret is in knowing how to manage risk.


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