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Robert Abbott
Robert Abbott
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Strategic Value Investing: Tolerance for Risk

Your capacity for bearing investment risk is based on both your ability and your willingness; and why it’s OK not to be willing even if you are able

September 13, 2019

Self-examination is the broad theme of chapter 13 of "Strategic Value Investing: Practical Techniques of Leading Value Investors." In the third section of the chapter, authors Stephen Horan, Robert R. Johnson and Thomas Robinson focused on the trait of risk tolerance, having already looked at patience and regret aversion.

What we’ve learned so far in this book is that value investing can reduce risk; we’ve seen many references to margin of safety, the gap between intrinsic value and market price. The larger the margin of safety, the lower the risk, and vice versa.

Risk also includes the differences between classes of securities. As noted, value stocks are less risky than growth stocks, and small-cap stocks are riskier than large caps. The authors offered this table showing the differences in returns and risk (as measured by variability of returns, or the standard deviation):

Strategic Value Investing GuruFocus capitalization and investment strategy

Value stocks and small caps outperform over the longer term, at the price of additional risk (with the exception in this case of small growth stocks having slightly higher volatility than small value stocks). Generally, then, value investors should expect to live with more variability, more volatility.

This is where temperament comes into play; traits such as patience and risk tolerance are essential if value investors are to stick to their plans. Of course, investors who prefer less volatility would likely put mostly large-cap stocks in their portfolios. Where you are on the risk spectrum will be determined by your willingness and ability to bear risk.

These are the two aspects of risk: willingness and ability. The latter refers to issues such as age and financial goals. For example, a younger person has more years in which to save, or recover from a loss, and so has more ability to handle risk than an older person. Financial advisors have a rule of thumb covering this: 100 minus your age. If you’re 40 years old, you would subtract 40 from 100, which equals 60, and thus you would allocate 60% of your portfolio to stocks and the remaining 40% to bonds or other relatively safe investments. Each year you reduce your equities exposure by 1%.

Similarly, someone who has a solid base of savings has greater ability to tolerate risk than someone who has not. The authors offer the example of a young professional with a job that pays well and many years until retirement. They obviously can take greater risks than someone close to retirement who receives a modest paycheck.

Essentially, the higher your ability to take on risk, the more investing choices you have. Consider someone like the young professional described above; they could create a portfolio with a heavy allocation to small-cap stocks.

Willingness to bear risk cannot be quantified in the same way as the ability to bear risk. Of necessity, it needs to be qualitative since it is based on feelings and emotions.

To gage your own willingness, you might try a question that’s used by some financial advisors; it goes something like this: “If your portfolio went down X%, would you be upset enough to stay awake at night and wish you had never invested at all?”

Suppose X is 10%, and you would get upset at that level, then your willingness to bear risk is low. On the other hand, if X is 30% and you would not be perturbed, then you do have the stomach for bearing risk. The authors also cited a test devised by Meir Statman, a behavioral economist at Santa Clara University; he asked:

“Suppose your portfolio is currently invested in cash and you have an opportunity to invest it such that you have a 50/50 chance to increase its value by 50 percent. However, the investment strategy also has a 50/50 chance to reduce the portfolio’s value by X percent. What is the maximum X percent value loss you are willing to accept?”

Interestingly, there are geographic differences among respondents:

  • Chinese and Vietnamese investors were willing to risk 16% to 17% for a 50-50 chance of a 50% gain.
  • Investors in Brazil and Tunisia were only willing to risk 10% of their capital on the same deal.
  • American investors clocked in at 12.6%; that is, they were willing to risk that amount on a 50-50 chance of gaining 50%.

When looking at these responses, remember they are averages:

  • Your degree of willingness will change as you age.
  • It will also change as you gain investing experience.
  • It may change with life experiences.
  • Tests may be insightful, but they reflect hypothetical losses; in real life, we may be less tolerant of risks.

The authors observed that while young people have the greatest capacity for risk, they often choose an asset allocation that is too conservative for their circumstance. That can have adverse effects in their retirement years.

Another important factor in one’s willingness to shoulder risk comes in the form of the economic outlook. Many investors are willing to take risks in bull markets, but turn shy in bear markets. That’s ironic because value investors see big opportunities in depressed stock prices.

As we know, many investors who have watched their portfolios contract in bear markets lose their tolerance for risk altogether. They sell all their stocks and retreat to bonds and other low-risk instruments just as bargain-hunting season really begins. That is just the opposite of what a wise investor does. Warren Buffett (Trades, Portfolio) may have summed it up best: “Be greedy when people are fearful and fearful when people are greedy”.

In two sentences that should be just as well known, the authors wrote, “Value investors don’t believe in the wisdom of crowds and instead speak of the madness of crowds. Just remember that, in investing, the phenomenon of regression to the mean has been fairly consistent through time.”

Conclusion

An investor's attitude toward risk depends on an ability and a willingness to shoulder risk.

There are differences between being willing and being able. Ability reflects your age and station in life and can be measured. Willingness is mostly subjective and while you may have the ability to bear risk, you may not be willing to do so.

The authors wrote, “It may simply be that you are not psychologically wired to do so. Realize that that’s OK. Being unwilling to bear risk is not a weakness. Choose an investment style that is consistent with your unique psychological profile.”

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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." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website


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