Investors speak of the “stock market” as if all securities trading on it are one and the same. What is more, their opinions of the “stock market” change together with its recent history, falling prey to the recency effect.
– “Invest in the stock market, you could make a lot of money.”
– “My friend invested $10,000 in the stock market and now he can retire from his earnings.”
After a turn of the bull market cycle, psychology changes and so does their reality.
– “The stock market is risky, you could lose all your money.”
An intelligent investor cannot analyse investment opportunities under the dogmatism of such banal and simplistic generalisations. If you buy the wrong thing, you definitely could lose all your money – but that is besides the point.
For starters, an investor must analyse the “stock market” one company at a time, because not all stocks are made the same. If a company is a new entrant in a fast moving and changing sector with a fragile balance sheet and a product line that has yet to prove its competitiveness, then business risk is high. Every case is different and a company doesn’t have to have any or all of the above characteristics to carry high business risk. You learn this qualitative aspect of analysing stocks with time and experience.
A company that is assessed to have high business risk basically means that there is a high chance that something can change in the future that could negatively influence the business materially or put it out of business altogether. No matter the valuation you buy it at, it can still go to 0. It is in these type of stocks that novice investors usually invest in (because of the promise of higher returns). Then when they get burned they blame it on the “stock market”.
Valuation risk is the risk that the valuation of a company trading on the stock market fluctuates negatively regardless of changes in its long term business prospects. One day the country, sector or specific company could be viewed more positively, the next day it could be viewed more negatively. This could range from things like minor short-term uncertainty to big events like the coronavirus pandemic. These changes in sentiment and expectations can result in significant share price fluctuations, whilst the long term quality of the business remains mostly intact.
True to the emotional biases of the human being, investors put more weight on immediate results (the short term) rather than delaying gratification (the long term). The effect of this is market volatility, bubbles and low quality investment decisions.
When an investor is swayed by recent stock market returns and rushes in to throw money in the hottest names at the time, he is assessing neither business risk nor valuation risk. The way he sees it, it is unlikely that he will lose money. The investor could indeed make a quick profit, but generally it makes sense to buy cheap rather than expensive. When it feels easy to invest and investors are euphoric is when securities are usually expensive.
This means that investors tend to buy at higher and higher valuation risk, and tend to stay away or sell what they own at lower and lower valuation risk.
The allure of hot industries with momentum is stronger for the novice investor, so when he does invest in the stock market, that is the kind of shares that he tends to buy. Old economy companies with entrenched business economics, growing slower than momentum stocks are also lucrative to them, but less so.
This means that, again, an amateur investor tends to invest in companies that carry high business risk. This might be working great for them in the medium term and indeed allow them to retire from a mere $10,000 investment – but who is to guarantee that Tesla will dominate the EV market in the end? How impossible is it that Tesla could be down 50% during the next 18 months? (At the time of writing the date was March 24th, 2021)
I have no positions in Tesla nor am I making any predictions – but the higher the business risk, the higher the uncertainty. Investors investing in high business risk could either make a killing or get killed.
Before making an investment decision, always consider first what your risk is. Is your investment operation a speculative one, or a prudent one?
For the purposes of this letter I only use high risk and low risk, and nothing in between, simply to illustrate the spectrum ends of investing. On the one hand you could be engaging in a high business risk investment with a risk of permanent loss, and on the other hand you could be investing in a high quality business with low risk. There are of course no guarantees in life and more so in investments, everything is relative and different investors can have differing views. A high business risk company for one person could be low risk for another, and the opposite.
If you knew exactly what a business would do in the future, the only thing that could change your future returns on the investment is the price you pay for it. Price acts as a weight to future total returns – the lower the price the better. Hence why I wrote that the investment risk “depends”, it is dependent on price.
There exists an investment axiom which stipulates that high risk brings high reward, and that low risk brings low reward. Generally, there is a wide belief that risks are correlated to rewards.
Even if there existed a magical capitalistic constant which equated risk with reward – this could not hold true because there is another “magical” variable which changes all the time shifting the balances of risk and reward anywhere it pleases, and that variable is price. Let’s scientifically test this axiom and see if it holds.
If risk = reward, then 1 unit of risk = 1 unit of reward. This is what the risk = reward hypothesis stipulates. There is no price in this equation.
However in the real world things are different. Hypothesising that at $10 / share, 1 unit of risk is equal to 1 unit of reward. If price drops to $8 / share, ceteris paribus, you have less risk for more reward. Therefore, the risk = reward hypothesis is directly falsified when price is applied to the equation.
Inversely, if price increases to $12 / share, ceteris paribus, you have more risk for less reward. Again, risk does not equal reward and the hypothesis is falsified.
Finally, the logical conclusion from the falsification of the risk equals reward hypothesis above, is that an investor’s aim should be to make positive asymmetry investments (i.e. investments that carry more upside than downside).
For example, “If things go as I expect them I will triple my money, if they don’t my investment is expected to drop by 25%.”
“The payoff of a human venture is, in general, inversely proportional to what it is expected to be.”
-Nassim Nicholas Taleb