One of the key characteristics of stocks and investing is that every piece of paper that represents a share ownership in a company comes with it a possibility that it may become worthless if the company goes out of business. That level of probability increases and decreases as the company evolves and is managed. Every single stock has this quality. When we are evaluating every investment opportunity some time needs to be dedicated to understanding this probability or more specifically the risks that come with owning stocks.
On the investing depth chart, stocks are the most risky asset class because of this probability that a company can stop functioning if it runs out of capital or money. When a company goes bankrupt or is forced to liquidate its assets, stock holders are at the end of the line behind creditors and bond holders in getting access to their money. Despite being the riskiest asset, it also offers the greatest promise of capital gains. It represents the classic risk/reward paradigm. In my learning modules, I dedicate a whole session on understanding and measuring risk. It’s just too important.
Unfortunately in the last several years, I am observing that the whole concept of risk is being overlooked and downright eliminated as part of evaluating stocks. There have been a few reasons behind it.
Since the Credit Crisis of 2008-09, Central Banks around the world have been in a race to stimulate tepid economic growth through various monetary policy actions such as lowering interest rates to near zero, printing more money to flood the financial system, and overtly entering the market and buying Government bonds to keep the costs of borrowing attractive and to stimulate the economy. What it has done is reduce options where investors could put their money to get a decent yield. Near zero interest rates doesn’t do much for income oriented investments like GIC’s or corporate bonds as the yields are next to nothing and in some cases negative and not keeping up with inflation. The only place where you can potentially get a decent yield is in stocks and so over the past 6 years, money has been pouring into stocks…any kind of stocks. It hasn’t matter what the business model of the company is, or how undervalued or overvalued the the stock is, money has been getting parked big time in the stock market. It hasn’t mattered if the company had a lousy balance sheet, minimal profitability or consistent free cash flow. The poster child for this has been IBM which have seen revenues flat yet continued to post earnings that made Wall Street analysts happy thanks to an aggressive policy of buying back stocks which are masking a serious business related issue for the company.
This shunning of risk by investors can be best represented by the Volatility Index or VIX index. The VIX represents the rate of change of stock prices in the S&P 500 index. It to a certain extent represents the level of fear that investors have for stocks. Over the past 5 year, the VIX has been tracking in the mid- teens level, indicating that investors have been quite comfortable putting money in stocks even with the higher risk profile in play. To put some context in this, during the financial crisis, when investors were abandoning stocks in droves, the VIX was tracking in the 50 to 60 level.
Exchange Traded Funds
Exchange Traded Funds or ETF’s have become the “It” investment vehicle for getting immediate exposure and diversification to the equity markets, specifically those that invest in the broad indexes like the S&P500 or the TSX/S&P Composite, or the Nasdaq. The premise with an ETF is that it will invest in all the stocks of an index, so an S&P500 ETF will buy at least one share of each of the 500 stocks in the index. I always view ETF’s as the equivalent of putting a chip on every number on roulette table or buying a complete set of hockey or baseball cards. The reality is that from my experience analyzing stocks, on average ½ of the companies on an index are not very profitable or can demonstrate consistent solid financial performance, however money will still be allocated and invested in those under-performing stocks via ETF's or index oriented funds. The premise here is that investing in all of the stocks will lower the risk profile compared to owning a specific stock which is consistent with the classic don't put all your eggs in one basket paradigm.
The Re-branding of Risk
Risk is currently undergoing a slow re-branding process. It has been nipped and tucked and presented to us in a new form, namely costs. The other value proposition for ETF's is that they charge much lower management fees compared to traditional mutual funds. Many of the brightest financial minds often speak of ETF's as cost effective, which is true to a certain extent, however even though they might be cheaper that doesn't mean they are less risky, however, the discussion and evaluation of ETF's often emphasize the cost component rather than the risk component. Slowly we are seeing a developing mantra that low cost ETF's are being marketed as lower risk investment vehicles which is far from true. While it is unlikely the Nasdaq or the Dow Jones Industrial Average indexes will go to zero, they are very likely to suffer price shocks and crashes that can impair our portfolios long term and low cost ETF's cannot mask this risk. Risk must always carry a bigger weight than cost. An ETF that carries a cost of 0.05 percent maybe cheap, however if the ETF drops 10 or 20 percent, that cost effectiveness will test our resolve.
The Last Vestiges of Risk
The only area where I see risk mentioned or given some level of lip service is at the front end of interaction with financial advisers, both human and online form via risk profile questionnaires which attempt to gauge the strength the ability of an investors to stomach a market downturn. At the end of the exercise the investor will still be recommended to build a portfolio of risky assets like stocks it's just the quantity of that exposure will be calibrated to their risk tolerance. It's reasonable however it can potentially create a false sense of security. What concerns me is this triaging of risk tolerance is done just once. What's to say people's tolerances change as they get older or they become more financially literate? Very little follow up is done.
Risk a four-letter word that needs to spoken more often and should always be a talking point when framing investment decisions. Recent economic events and an industry that is trying to reinvent itself are guiding a new generation of investors to literally throw caution to the wind. History has shown that such a mindset could have serious consequences. Take heed.