Guard against permanent capital loss, weigh the fundamentals, diversify, take longer view
The stock market has currently been more erratic than a poorly made firecracker. But there is nothing new about that.
In the short term, the stock market can be as random as rainfall in Singapore.
The unpredictability of share prices can give rise to the notion that stock market investing is risky. But there is no proper definition of stock market risk. There is no one-size-fits-all definition that adequately explains what the various risks really are.
Just take a look at some of the risks that we expose ourselves to when we buy shares.
We have to contend with political risk, if we buy shares in companies with overseas exposure. We have to cope with currency risk, if a business has assets sitting in a foreign country. We have concentration risk, if we should buy too many shares of companies that operate in the same industry. Concentration risk is also at play when we invest in too many companies that operate in the same country. We have war risk, but the less said about that the better. We also have business risk, default risk and, of course, the daddy of all risks – market risk.
Each of those risks could impact the way that stocks behave. Typically, when there is a bad smell in the air, some investors will sell up and head for the hills because cash is less volatile than stocks. Shares have a terrible habit of bobbing up and down with almost every snippet of news.
The act of shares bobbing up and down has a technical name – volatility – which academics like to equate with risk.
In other words, when a stock reacts with greater volatility than the overall market, then it is deemed to be more risky. Consequently, many investors perceive volatility to be bad.
But volatility cuts both ways. It not only means that a stock could fall more than the market but it could also mean that the stock could rise more than the market. If we profit from volatility, then risk is seen to be a good thing. But if we lose money as a result of volatility, then it is deemed to be bad. But we cannot have our cake and eat it too. The conundrum presents us with, perhaps, a more suitable definition of risk – it is that risk is the permanent loss of capital.
So, as savers and investors, we have a choice. We can either embrace volatility or sit on a pile of cash, which many perceive as being risk-free. But cash, ironically, is probably the riskiest of all possible investments, as it can lead to a permanent loss of capital if we sit on it for too long.
Cash unless it is put to work will slowly be eroded by inflation. Even at a modest inflation rate of 2 per cent, $100,000 will have the buying power of just $50,000 after 36 years. If inflation returns to its long-term average of around 3 per cent, then the buying power of $100,000 could halve in just 24 years. That represents a permanent loss of capital, simply by doing nothing.
So what can one do given that cash carries inescapable inflation risk and the stock market is plagued with a gamut of risks? The answer lies in my preferred definition of risk, namely, the permanent loss of capital.
Buying shares could admittedly result in a temporary loss of capital, should volatility cause our investments to fall below the price that we paid for them. But as legendary investor Benjamin Graham pointed out: “In the short term, the stock market is a voting machine; in the long term, it is a weighing machine.”
Consequently, our best defence against making a permanent loss is to avoid overpaying for our investments. That means weighing up the fundamentals of the company. These could include the competitive advantage of the business, its ability to generate cash, market share, the debt burden and the competitive environment. Even forensically examining every aspect of a company might not be enough to insulate our investments, entirely. That is why it is important to diversify by building a robust portfolio of stocks. Even then, diversification will not protect you, unless you are prepared to adopt a multi-decade investing horizon.
By doing so, short-term declines in the stock market will become less important.
It also means that we should continually add money to our portfolios, whenever we can. Another legendary investor, Peter Lynch, was right when he said: “In the long run, a portfolio of well-chosen stocks will always outperform a money-market account.” But Albert Einstein, who is, perhaps, not renowned for his investing prowess, put it even more succinctly. He said: “A ship is always safe at the shore – but that is NOT what it is built for.”
•This is the start of a regular monthly column on stocks and investing by David Kuo, the chief executive officer of The Motley Fool Singapore.