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Robert Abbott
Robert Abbott
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Value Investing: Risk Issues

What is risk for value investors, and what can they do about it?

January 20, 2020

Every kind of investing, even value investing, demands at least some knowledge of risk.

Blaine Robertson has addressed the issue in chapter eight of “Value Investing: A Comprehensive Beginner Investor’s Guide.” And, in doing so, he gave special attention to value investors, who try to identify opportunities with low risk and high earnings potential. Further, he argued that to be a good value investor, your risk management practices have to be “top-notch.”

Risk has two key attributes: vulnerability and results. Robertson cited the Commission on Insurance Terminology (created by the American Risk and Insurance Association), writing, “Vulnerability with regards to the result of an occasion when at least two conceivable outcomes exist.” He went on to note that risk can be a danger (a negative outcome) or a chance (a positive outcome).

Types of risks

There are two broad types of risks that investors face:

  • Systematic risk: This type is associated with types of assets, such as stocks or bonds. In the case of bonds, there is a systematic risk because they are vulnerable to rising interest rates (making their face value go down).
  • Unsystematic risk: This refers to the risk associated with individual organizations, such as companies. Therefore, in buying a stock, you are taking on unsystematic risk. For example, a company that loses a major customer, is being sued or makes poor management decisions produces this type of risk.

Within that context, we can identify other risks:

  • Business risk: anything that causes working income (or earnings before interest and taxes (EBIT)) to fluctuate.
  • Financial risk: think of debt here, and the fixed-interest payments that must be made.
  • Liquidity risk: If a company cannot convert enough of its assets to take care of its immediate debt obligations, it is illiquid and may fail, thus increasing its vulnerability.
  • Market risk: This refers to market-wide changes that affect all companies; for example, rising interest rates.
  • Equity risk: Involves share prices, in the sense that they are affected by demand and supply in the market.
  • Interest rate risk: Debt securities, such as bonds, are sensitive to changes in interest rates.
  • Currency risk: This is specific to international investors, whose assets are affected by changes in currency values.
  • Inflation risk: This involves the purchasing power of money; as we know, inflation erodes purchasing power, which indirectly affects the value of our assets.

The concept of higher risk for higher return

Some investors believe there is a direct relationship between risk and returns; that investors must take greater risks to earn higher returns. It’s one of the conclusions that arose out of the efficient market hypothesis (or theory). That theory concluded that all relevant information that investors need is equally accessible to all participants in the market. In turn, that meant all assets in the market are fairly priced, and the only way to earn above-average returns was to take on extra risk.

Yet, that is not necessarily the case, as we know from the track records of gurus like Warren Buffett (Trades, Portfolio) and Peter Lynch. In fact, all value investing contradicts the theory.

Risk management

Robertson also offered his thoughts on risk management by investors, in both broad and specific terms. He pointed out that risk management is not a linear procedure; instead, it is “the adjusting of various interlaced components which communicate with one another and which must be equal if risk management is to be viable.”

Value investors must properly categorize risks, into the categories listed above. They must understand the risk or risks that their companies face and know how their portfolios might be affected by different outcomes. There are several ways to de-risk a portfolio:

  • Diversification: This means not putting all your eggs into one basket or stock. As we saw above, there are risks that are specific to individual companies, risks that may be offset by buying smaller stakes in two or more companies.
  • Stay away from companies with heavy debt burdens: Using the leverage that comes with high debt levels can produce excellent returns—or wipe them out altogether. Debt is always a double-edged sword, capable of delivering losses as well as above-average returns. In particular, borrowing too much sometimes leads to bankruptcy, which is a disaster for investors.
  • Put your money into “blue chips,” which is to say, large and established companies with a history of delivering steady returns, year after year. This would mean buying fewer companies that offer potentially wonderful returns at high risk and buying more of those that consistently deliver reasonable returns.
  • Avoid leverage and margin. Like companies, investors can borrow to increase their returns. But these investors are making themselves vulnerable to stock hiccups, and thus taking on additional risk. To clarify, “margin” refers to borrowing money from your stockbroker, while borrowing from other sources would be considered “borrowing” or “leverage.” Note that leverage also includes trading stock options in hopes of magnifying returns.

Conclusion

Risk must be an inherent part of investing, if for no other reason than investments are made in the expectation of benefits that will arrive in the future. Of course, the future is unknowable, so making any commitment that involves the future must necessarily bring on risk.

In this chapter, Robertson has explained what risk is, its many variations and how to manage it. The takeaway would be that value investors should know they are taking on risk, and should prepare themselves to deal with it.

Finally, I believe the chapter would have been stronger had the author included the distinction between risk and uncertainty. The former refers to situations in which outcomes can be predicted, albeit across a wide range of probabilities. Uncertainty, on the other hand, refers to situations in which outcomes cannot be predicted at all. This all means that risk can be managed, but uncertainty cannot.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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