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For 2014, Let’s Understand What Risk is All About

Worried

Risk is one of the most misunderstood concepts in investing. During the festive season a few weeks back, I was having dinner with a group of close friends. One of them asked me, in my own personal capacity, how he can grow his savings over the long-term, apart from just saving more.

Stocks”, I answered. “But, aren’t stocks risky? They move up and down all the time, and are prone to collapses”, he questioned.

That, for me, was again a sign that there are indeed likely to be many who are confused about investing risks.

And, it certainly doesn’t help that we have a whole host of market participants equating price volatility (otherwise known as “beta”) with risk. But, price volatility isn’t really risk, especially for investors with decades to invest. It’s the start of a new year in 2014 and perhaps a good time as any to try and set the record straight.

Re-thinking risk

Here’s how famed investment author William Bernstein thinks about risk, as described by investing author and Wall Street Journal columnist Jason Zweig in his article titled ‘Shallow Risk’ and ‘Deep Risk’ Are No Walk in the Woods (emphasis mine):

[Risk] takes two basic forms – and understanding the difference can help investors figure out what they should be afraid of.

What Mr. Bernstein calls “shallow risk” is a temporary drop in an asset’s market price; decades ago, the great investment analyst Benjamin Graham referred to such an interim decline as “quotational loss”.

Shallow risk is as inevitable as weather . You can’t invest in anything other than cash without being hit by sharp falls in price.

“Shallow” doesn’t mean that the losses can’t cut deep or last long – only that they aren’t permanent.

“Deep risk,” on the other hand, is an irretrievable real loss of capital, meaning that after inflation you won’t recover for decades – if ever.”

So, what beta is trying to capture, and what my friend was afraid of, was shallow risk. But, that’s not really risk because it’s something investors can recover from if they have the fortitude to hold on to their investments in the face of seeming-calamity.

Volatility in the markets is just the nature of the beast. It is the cross that all investors have to bear in their quest to generate lasting and meaningful long-term wealth from the stock markets.

Now, deep risk is something that all investors should fear. Bernstein provides four examples that can cause deep risk to surface: inflation; deflation; confiscation (through seizures by governments as happened to bank depositors in Cyprus, or through a massive increase in taxation); and devastation. Those are great and thoughtful examples, but I’ll like to add on bankruptcy and overvaluation to that list.

Deep risk 1: Bankruptcy

A company going bankrupt is one of the easiest ways for shareholders to lose their shirts as shareholders in such a situation are almost always the last in line to get anything (if there’s even anything left) from bankruptcy proceedings.

To avoid this form of deep risk, there are clues investors can glean from a company’s operating history as well as its balance sheet that can point to potential trouble.

For instance, my fellow Fool Stanley Lim has pointed out how companies like Aussino Group (SGX: A15), China Powerplus (SGX: Z02), and FDS Networks Group (SGX: F07) are under a watch-list of companies with three consecutive years of losses that’s maintained by stock exchange operator Singapore Exchange. Nothing’s set in stone, but if a company’s constantly bleeding red ink, there’s a higher risk they might face bankruptcy in the future.

As for the balance sheet, debt-laden companies often face higher financial risks. As the late super investor Walter Schloss once put it (emphasis mine), “I like to look at the balance sheet and I don’t like debt because it can really get a company into trouble.” Keep an eye out for weak balance sheets, and chances of walking head-on onto deep risk can be lowered dramatically.

Deep risk 2: Overvaluation

The other source of deep risk I suggested would be overvaluation. How does that work? Logistic and data centre services outfit Keppel Telecommunications & Transportation (SGX: K11) was worth some 57 times its trailing earnings back in Oct 2007 at S$4.70 a share. In the six-plus years since, its fundamentals couldn’t keep up as earnings went up a grand total of only 29%, leading to its share price being 62% lower today at S$1.77.

Here’s one more example: Blumont Group (SGX: A33) and Asiasons Capital (SGX: 5ET) were both selling at 500 times or more their trailing earnings shortly before their shares collapsed more than 90% in three trading days from 4 Oct 2013 to 8 Oct 2013. There was simply no business-fundamentals to support such extreme valuations. Both companies’ shares are still languishing as of today.

For investors who had invested in both, it would likely take a long, long time (if it even can be done) before their capital’s ever recovered, considering that it would take a 1,000% climb to recover from a 90% decline.

That’s deep risk for you. It’s dangerous and costly but in certain instances, it is avoidable, as it is with bankruptcy and overvaluaed situations.

Foolish Bottom Line

It bears repeating that for investors with decades to invest, shallow risk really isn’t risk at all. It’s a permanent loss of capital – the deep risk – that they have to fear. But, like I mentioned, there are ways investors can avoid them, and Zweig also describes ways to deal with Bernstein’s other sources of deep risk in his article I referenced earlier.

On a final note, here’s an example of why volatility really doesn’t matter in the long-run.

From 1988 to 2013, the Straits Times Index (SGX: ^STI) has declined by more than 20% from its peak to trough in each calendar year in 8 separate years. That’s volatility at its finest, a huge dollop of shallow risk. But, what has happened to the index in those 25 years? It has climbed 280% – or 5.3% annually on average – from 834 points to 3,167 at the end of last year.

Take that, shallow risk!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.