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How A Risk-Averse Investor Should Invest

In our Ask A Foolish Question exercise conducted back in September last year, we invited our readers here at The Motley Fool Singapore to send in any of their investing-related questions which we would then try our best to answer. One of the questions posed to us went like this (quoted verbatim):

If I have spare cash in the bank (let’s say $500k), what is the best way to invest these money. I would say that I am average in terms of risk appetite.”

It’s an intriguing question because the reader mentioned his/her risk appetite. This got me thinking – what exactly is risk?

In most of the financial world (or at least in the majority of finance textbooks), risk is often measured with price volatility, with beta being the common tool used. How wide are the price swings in a particular asset class? That constitutes risk in the eyes of many.

But in my opinion, that’s not exactly the right way to think about risk, especially if you’re a long-term investor. Charlie Munger, long-time sidekick to billionaire investor Warren Buffett and vice-chairman of American conglomerate Berkshire Hathaway, describes risk as such:

Using volatility as a measure of risk is nuts. Risk to us is (1) the risk of permanent loss of capital, or (2) the risk of inadequate return.”

In other words, risk comes from (1) assets that go down in price and then permanently stays down or it can come from (2) your investments not appreciating fast enough to meet your goals.

If risk is thought of in those terms – as it should be – then the idea of a ‘risk appetite’ becomes moot. Instead, the reader’s question should have been this: “How should I invest $X, given my goal of getting Y% returns to fund my goal of <insert your own scenario>”

Having a goal is important because we can then base our investing decisions and future plans on it.

When value investor Mohnish Pabrai first started investing, he had a goal of earning 26% average annualised returns over the long-term. Because of that, Pabrai only sought after investing opportunities where the discrepancy between the price of a share and its underlying intrinsic value allowed him to make such returns.

In other words, Pabrai’s opportunity-set was determined by his goal. Even billionaire investor Warren Buffett had set an explicit goal when he first started managing money in his investment partnerships in 1956 – he proclaimed his desire to beat the Dow Jones Industrial Average (the predominant American stock market index at that point in time) by 10 percentage points per year and promptly invested with that goal in mind.

If all an investor required to fund his goals were annual returns of slightly more than 2% per year for decades into the future, a simple investment into long-term Singapore government 10-year bonds would likely have sufficed.

An investment into the Straits Times Index (SGX: ^STI), which has grown at around 5.4% per year since 1988, would be a delightful surprise for the investor if the index can keep up with its historical performance.

On the other hand, if he needed his investments to grow at 15% to pay for his daughter’s university education in Australia in 20 years’ time, he would likely be setting himself up for the huge risk of failure in meeting his goals if he decided to invest his funds solely into the STI through index trackers like the Nikko AM Singapore STI ETF (SGX: G3B) or SPDR STI ETF (SGX: ES3).

For now, let’s take it that you accept at face-value, the importance of goal-setting in determining how we invest. That, however, still leaves the question of how we should go about doing it unanswered.

On that front, let’s turn to the definition of risk as a permanent loss of capital for some guidance. To achieve our goals, we naturally cannot invest in such a way that exposes us to great odds of losing money

And for risks of permanent losses to occur, the quality of the asset being purchased in addition to the price that’s paid relative to the intrinsic value of the asset (where its value is derived predominantly from its quality) would be of great importance.

For shares, the quality of the asset – in this case, the underlying businesses – could perhaps be determined in terms of its financial stability and its ability to remain profitable over the years. Financially unstable companies – those with bloated balance sheets full of debt, for instance – run the risk of bankruptcy, which would in all but the rarest of cases, leave shareholders holding a bag of air.

As for profitability, I’ve shown before how chronic loss-makers like Stratech Systems (SGX: S73) and China Kunda Technology Holdings (SGX: GU5) have been long-term losers due to their inability to turn in a profit. Businesses that can’t make a profit can’t possibly make any money for their owners over the long-run.

That’s not to say, however, that buying great businesses – the ones that are financially stable with good prospects of growth ahead – indiscriminately would naturally give one an edge.

If I were to ask you 13 years ago how much you would be willing to pay for every dollar of profit for a particular company that would in time to come, more than double its revenue and triple its earnings, how would you answer?

If you said paying $72 for each $1 of profit was fair game, you would now be sitting on absolutely flat returns – less than zero, in fact – after 13 years. That’s what happened to investors in American software giant Microsoft in 2000.

Buying shares when they are highly priced in relation to future underlying profits and cash flow will always be a recipe for disaster with Microsoft being one such dish.

Foolish Bottom Line

So, to bring it all together, an investor should first know how to avoid making permanent losses. When that’s done, set a goal. The goal could be a particular return-target just for bragging rights or it could be a target-sum of money for your child’s university education – it doesn’t matter. What’s important is to have a goal in mind. When that’s done too, then perhaps the question of how best to invest that money (or whether an even larger sum of money might need to be contributed in order to meet the goal) can be addressed.

Most investors are likely to be risk-averse with average or minimal risk-appetites. But not many truly understand what risk is. To learn more about risk and investing, sign up now for a FREE subscription to The Motley Fool’s weekly investing newsletter, Take Stock Singapore.  Take Stock Singapore shows how you can grow your wealth in the years ahead.

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An earlier version of this article was first published on fool.sg in October 2013. The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns B-Class shares of Berkshire Hathaway.