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Risk: Not Just a Four-Letter Word

Risk: Not Just a Four-Letter Word

By    |   Friday, 18 May 2018 07:20 PM

There’s no concept I think about more when it comes to investing than risk.

You should too. Understanding risk—and how to mitigate it— is the difference between being powerless when the market inevitably corrects and having a plan in place to deal with it. Thinking about risk in both traditional and non-traditional ways is crucial to growing your wealth over time.

There are many ways to measure risk. Most professional financial professionals look at a stock’s historic performance. From that, they can calculate a stock’s beta, or how volatile a stock is on average compared the S&P 500 Index (the index has a beta of 1. Anything higher is more volatile, anything under 1 is less volatile).

A company with a beta of 2, for instance, should expect, on average, should go up 2 percent when the S&P 500 goes up 1 percent. A company with a beta of 0.5, should only move half a percent for every percentage move (up or down) in the S&P 500.

So in those terms, a high-beta stock is great in a bull market, but when things change, high-beta stocks will get whipsawed far more than your portfolio as a whole. If you expect a short-term market swing, buying a high-beta stock (or buying call options on a high-beta stock) can set you up for a nice short-term profit relative to the risk.

But that’s just one technical way of looking at risk. It’s just a way of looking at a stock as a price that moves. In the real world, where you and I live and invest, we need to look at risk in a more understandable way: at the company involved, and how to best profit from a move in shares.

I look at risk first and foremost in terms of potentially losing my entire investment. To me, that’s the prime risk. There’s no point in investing a single dollar on something that may or may not go bankrupt.

That goes beyond a stock’s historic price and to the underlying company whose shares I’m buying. If it’s a great company, I may take on some short-term market risk, but the risk of the company going under or becoming obsolete needs to be small to none.

For instance, investors in 2009 who just saw the carnage unfold during the financial market were throwing out good stocks along with bad ones. While many bank stocks fell 90 percent or more, some great companies were down nearly 40 or 50 percent from their then-highs.

You could have gotten the Walt Disney Company (DIS) for under $20. It’s now up over five-fold. Ditto with Microsoft (MSFT), whose returns in the tech space pale in comparison to the post-crisis performance of Alphabet (GOOG), and Amazon (AMZN). While these companies definitely took a hit, and likely always will in a recession, their risk of bankruptcy was low. That’s a huge factor to consider the next time the economy is in the dumps.

The financial crisis created a lack of liquidity. Companies with high levels of debt, particularly short-term debt that needs to be continually refinanced, face the biggest danger when credit markets freeze up or close outright. That’s why a company’s relative debt levels, as well as how often it needs to go to the credit markets are a key indicator to watch.

Second, like you, I don’t have an infinite amount of money to invest. So I can mitigate some of my risk by using options to control shares. That’s another place where many investors get hung up. Yes, options can be riskier, but only when they’re used improperly.

Say I expect shares of Home Depot (HD) to rise. At nearly $185 per share, 100 shares will mean putting up $18,500. But if I can buy a call option for, say $15, or $1,500 for a contract, I can control 100 shares for less than 10 percent of the cost of buying 100 shares.

Of course, an option in that sense is like a lease—it’s got to be used quickly or else the time premium will slip away. That’s where the risk comes from that you don’t get from buying and holding shares. But if Home Depot shares go up 10 percent, I should get a great percentage gain on my options—one that is proportional to what I would have gotten had I bought shares in the first place. In short, I can control a lot of shares for a smaller price by using options.

Again, this is a tremendous advantage smaller investors have over larger ones. We can lower our risk by essentially renting shares at a fraction of the cost of buying them. Getting into and out of a large number of options trades may be too difficult for institutional funds.

Of course, I don’t want to buy call options on every stock I’m interested in buying all the time. Some companies are worth buying as long-term income plays thanks to a rising dividend payout over time. Other companies may be down on their luck now, but don’t look ready to rally yet.

Those companies are great for selling put options instead, rather than buying calls. It’s a different way of going long on a company—you’re essentially taking on the risk of buying shares if they fall further. It’s one strategy I keep coming back to again and again with great companies with low bankruptcy risk. I can either set myself up to make at least 10 percent per year in option premiums, or I can take on shares and hope for the best. Every stock and situation is different.

Risk can be recognized and reduced, but it can’t be eliminated. But if you’re taking your riskiest investments and using options instead of shares, you can get a similar return with a lot less money at risk. And if you buy low-beta, high-yielding dividend stocks, you can create a growing income portfolio to more than offset those options trades that don’t play out.

Don’t be at the mercy of risk. Master it.

Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.

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If you buy low-beta, high-yielding dividend stocks, you can create a growing income portfolio to more than offset those options trades that don’t play out.
risk, investor, investment, buy, shares
Friday, 18 May 2018 07:20 PM
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