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Risk; Final Words October 4, 2008

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In the investment world, like life in general, you can never avoid risk.  Instead of trying to avoid the unavoidable the point is to embrace and manage risk.  The best way to do that is to build a plan and stick to the plan until something fundamentally changes.  Its funny, people have made money trading in stocks, have made money by buying and holding stocks, and by investing in fixed income securities, investing in real estate, but they all say the same thing; I constructed a plan and stuck to it!

What that should tell us is that you need to build a plan that has staying power.  If you are investing in real estate and have to flip a property in a short period of time because of negative cash flow, then you are asking for problems.  If you are investing in stocks and emotionally not prepared for down trends, haven’t plan for them, then you are again asking for problems.  There are ways to invest in stocks that doesn’t depend on stocks going up all the time and there are ways to invest in real estate that doesn’t depend on large amounts of capital appreciation.  That is what I am talking about when I say manage risk and embrace it.

The bottom line is active investors have a plan for all market situations, while passive investors don’t.  Active investors have a plan built on historic evidence, while passive investors don’tActive investors have accounted for all contingencies while passive investors haven’t thought about them. 

At the Shafer Wealth Academy (www.shaferwealthacademy.com)  we think about what history tells us will happen and we plan for it.  You don’t fear what you already are prepared for!

Risk III: Emotional Risk October 1, 2008

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I have had several “financial planners” who have told me in discussion that they don’t suggest certain strategies because their clients wouldn’t be able to sleep at night.  Although I don’t agree with the logic, there are certainly people who forego activities because of the “good night sleep” factor.

Emotional risk is pursuing strategies that so unsettle one as to keep them from behaving rationally. For example, every time the stock market goes down significantly, many people sell their mutual funds/stocks because they fear more loss. Other people fear debt so much as to pay down their mortgages or put large down payments on their houses feeling like there is less risk in this strategy. Or others never consider strategies or self-employment because of an emotional attachment to a weekly paycheck or consistent earned interest.

I argue that emotions can be overcome with rational planning. If you have a specific plan, employ it consistently, and track its progress then one can overcome the negative emotions, fear, with a positive emotion, comfort. But here is the sticky part. If your plan is only to overcome a negative emotion, like getting rid of debt or risk, then you will never get to that comfort part because as soon as you succeed, you will have another fear supplant the current fear and start the cycle over again.

For example, if you eliminated the risk of equities from your life, and had your money in a bank CD or savings account, the current bank failure scare would ratchet up your fear again and cause you to pull your money from banks.  Or if you were using your home as a savings account, paying down your mortgage, the current real estate market would again ratchet up your fear and probably cause you to lose sleep or even worse cause you to sell your home in a poor market.

The alternative is to build a plan that history has proven to work.  Put your emotional energy into the implementation of the plan, and allow for the long term financial winds to push you past the finish line!

  

Of course having a wealth coach to help build your financial plan and walk you through the implementation process might help too. 🙂

www.shaferwealthacademy.com for your wealth plan!

Risk II; Systemic Risk September 30, 2008

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Following up on our discussion of strategic risk yesterday, we will discuss systemic risk today.

Systemic risk makes up the majority of what most investment folks consider risk. Very simply it is variance. It is the total margin, both positive and negative, of the possible rates of return. For a stock the possible negative is -100% or total loss of all capital and the possible positive is infinity.  A stock can go up as high as its cash flow allows it.  In more practical terms the total possible can be thought to be +500,000% (Berkshire Hathaway has gone up 400,863% in the last 43 years). So we can reasonably say that any stock has a variance of 500,100% (500,000% + 100%)!

Now we see why mathematicians think that any single stock is tremendously risky! Now as a way to deal with this risk, most investment professionals suggest diversification. What diversification does is truncate the possible rates of returns. For example, if you own 20 stocks it is highly unlikely that all 20 will go out of business. It is also highly unlikely that all twenty will return anywhere near what Berkshire Hathaway did. So we can say with a good degree of certainty that the negative possibilities decrease from -100% to -80% and the positive possibilities from +500,000% to +10,000% (The S & P 500 Index went up 6,840% in the same 43 year time period). So diversification decreases the possible variation of rate of returns from 500,100% to 10,080%. Quite a difference and why mathematicians were so impressed with diversification!

Now, I want you to look at the numbers again. The risk is uneven or skewed. The upside has much more potential than the downside. With diversification you really bring the upside potential down, but only reduce the downside potential by a little.

Warren Buffett does not believe in diversification as a strategy to reduce risk because of this skewed situation. He thinks one can pick companies that have good management, good cash flow, business plans that make sense, products or services that aren’t going out of style, and product or name recognition that creates a protective moat around the business. He has demonstrated he can pick good companies. There are many others that do the same thing, just not in a publicly owned company.

The key take-away from this post is to understand that systemic risk equals variance and that it is skewed toward positive results. Your fear of loss of all your money (as opposed to 80% of your money) is costing you much upside potential! My point isn’t to tell you not to diversify, but only to illuminate what it is costing you. Knowledge is king!

This 10 year chart of Berkshire Hathaway versus the S & P 500 Index I believe illustrates what I have been saying.  Note, the much tighter range for the S & P than Berkshire.  Berkshire has a much higher systemic risk (variance) than the diversified index!  However, the payoff for assuming this risk is in upside movement!

Next post we will discuss the non-mathematical aspects of risk!