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
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
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
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
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
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
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
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
"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.