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A Quick Guide to Understanding Investing-Risks

A few days ago, Lawrence Wong, Minister for Culture, Community and Youth, said that there’s more to be done to help Singaporeans learn about investing as the basic principles are not well understood by the public.

In my opinion, one of the least understood aspects of investing is the topic of risk. So, here’s my attempt to help plug the gap with some help from investor and author William Bernstein.

The ABCs of risk

In his book “Deep Risk: How History Informs Portfolio Design,” Bernstein categorises investing-risks into two forms. Here’s how the Wall Street Journal describes it:

“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 inveitable 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 loss of capital, meaning that after inflation you won’t recover for decades – if ever.”

Put another way, shallow risk is simply market volatility. It’s like how Singapore’s market barometer, the Straits Times Index (SGX: ^STI), fell by 23% to around 2,600 points from peak-to-trough in 2011 before recovering by more than 26% (or almost all of its losses) to its current level of 3,288 points.

Market volatility is as natural as night follows day. But unfortunately, it’s also what most investors are fixated upon. This should not be the case. “The funniest thing about markets is that all past crashes are viewed as an opportunity, but all current and future crashes are viewed as a risk,” my colleague Morgan House once wrote.

If we’re investing for events that happen decades away (a happy retirement, a dream car, a house, your child’s education, or what have you), market volatility shouldn’t be feared. Instead, it should be looked upon as an opportunity to scoop up bargains.

Of course, there are cases where investors would require capital for whatever reasons, say, within the next three years. If so, I’d argue that such money shouldn’t even be invested in shares. And if an investor is not investing any short-term money, then shallow risk is taken out of the equation entirely.

Deep risk is another matter altogether as it can lead to a permanent loss of capital. Bernstein has four sources of deep risk: Inflation, deflation, confiscation, and devastation. I’d like to add on a few more here – extreme over-valuation, companies that become irrelevant, and ugly businesses.

Bubbly exuberance

The Japanese stock market is a great example of the harm that extreme over-valuations can bring. At the end of 1989, the Nikkei 225 (a rough equivalent of the Straits Times Index here in Singapore) was more than 38,900 points. Today, after more than 24 years, the index is only at 16,000, a decline of more than 50%. The reason? During its bubble-years in the late 1980s, the Nikkei 225 was valued at more than 100 times its trailing earnings at one point in time. When shares are priced so dearly, investors face a very high chance of suffering permanent losses.

For an example closer to home, Blumont Group Ltd (SGX: A33) would be emblematic. Near its peak price of S$2.45 back in September 2013, the company was valued at around 500 times its trailing earnings and 60 times its book value. Today, Blumont’s shares are worth S$0.025 apiece, a crash of 99% from its peak.

Fading into the sunset

The next source of risk deals with companies that become irrelevant. Since the start of 2005, printed classifieds outfit Global Yellow Pages Limited  (SGX: Y07) has collapsed by more than 97% in price. Its business became increasingly irrelevant over the years as more and more information and advertising got transferred onto the web.

With management unable to adjust to the changes, the company’s share price has suffered along with its business. Between 2004 and 2013, the company’s bottom-line has declined from S$13.3 million in profit to S$124.7 million in losses. Even the best buggy whip manufacturer would be worth next to nothing in the era of horseless carriages.

The bad, the ugly, and the gruesome

The last source of deep risk comes from ugly businesses – and billionaire investor Warren Buffett has given us a great framework to think about businesses which are not pleasing on the eye:

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earn little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

We have a couple of listed airlines’ in Singapore with Singapore Airlines Ltd (SGX: C6L) being the most prominent. Since the turn of the century, the full-service carrier has declined by 50% in price; after factoring in reinvested dividends, Singapore Airlines’ has gained just 5% after 14 years.

When we compare Singapore Airlines’ financials with that of a long-term stock market winner like Vicom Limited (SGX: V01), the differences become obvious.

Financial metrics Vicom Singapore Airlines
Capital expenditure as a % of revenue (average over last 13 completed financial years) 9.32% 18.31%
Change in earnings per share over last 13 completed financial years 517% -77%

Source: S&P Capital IQ

Vicom had required much lesser reinvestment of capital to produce growth as seen in the table above. This has allowed its shares to earn a massive total return (where gains of reinvested dividends are accounted for) of 1,860% since the start of 2000.

Foolish Bottom Line

Risk is a very important but not well-understood part of investing. If you’re a long-term investor (and everyone should be!), then know that shallow risk – also known as market volatility – simply fades away with time. It’s the deep risks we have to fear. But, the great thing about all these is that as investors, we have the opportunity and ability to lower these deep risks and thus make our investing experience a more fulfilling one.

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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.