Hype, poor research and concentration: investors’ biggest risks

You can also listen to this podcast on iono.fm here.

This is it – the finale of Supernatural Stocks. It’s been a great run on Moneyweb and I’m grateful to the editorial team for the opportunity.

So where to finish this off?

Over nearly two years, we’ve covered many local and international stocks. We’ve dealt with numerous concepts across sectors like banking, retail and cyclicals. And although we’ve delved into technical discussions along the way, I hope you’ve also realised the extent to which storytelling plays a role in equities.

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There’s so much that has been done, and so much that could still be done. But in figuring out how to bring this to a close, I found myself writing various notes that all came back to the same underlying concept: risk.

Without risk, there is no reward. And without rewards, there would be no point in participating in the market.

Risk should be respected and understood, not avoided. You can’t wrap your body up in cotton wool and waste your time on this earth.

The same is true for your money.

I therefore leave you with a collection of thoughts on risk, primarily focused on the distinction between avoidable and unavoidable losses.

I also wish you all the luck in the world in your journey through the markets! Supernatural Stocks has been a pleasure.

What is ‘risk’ anyway?

In markets, as in life, things are hardly ever straightforward.

Nothing is ever all good or all bad – instead, there’s a spectrum of potential outcomes, both positive and negative. These outcomes have various catalysts along the way – some of which can be predicted, many of which cannot.

This variability of outcomes is exactly why we talk about ‘risk’ in the market.

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But risk of what, exactly?

Volatility is the usual measure of risk, but is that actually correct? Should we really be worried about stocks going up or down in value on a daily basis, particularly if we’ve done the right thing and invested with a multi-year time horizon? What difference does it make in your life if a stock fell yesterday and rises today, unless you traded those moves?

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Risk of uncertain outcomes, perhaps? Not knowing exactly where your returns will end up? Sure, that’s a risk, but it’s hardly a disaster if your returns end up slightly better or slightly worse than expected. As long as you achieved a reasonable rate of return, you’re smiling.

But what about permanent capital loss? Isn’t that the risk we should really be talking about? It’s really hard for a portfolio to claw itself back from a major loss. If 20% of your capital is gone, you need a 25% return just to get back to where you started!

If we approach this discussion through the lens of a long-term investor, then I would argue that volatility isn’t the best measure of risk.

With a proper financial plan in place, ideally with the help of an independent financial advisor, you should have funds available for life’s little surprises.

Unfortunately, if your emergency fund is your portfolio, then volatility can – and probably will – bite you really hard, but you also deserved that outcome by looking for trouble.

Even without basic errors like not having sufficient emergency funds, it’s easy for poor decisions or weak portfolio discipline to turn harmless volatility into harmful permanent losses of capital. These are avoidable losses.

There are also unavoidable losses that are going to come your way in the market. Let’s deal with that next.

Unavoidable losses

Unavoidable losses are a feature of the market, not a bug.

Data tells us that markets go up in value over time, not down. Markets are just the average of all the underlying stocks in that index, so this means that most stocks go up over time, rather than down. But that doesn’t mean that all stocks will go up, or that your stocks will go up.

Even if you do things the right way, by holding a diversified portfolio of sensible stocks bought at reasonable prices, there are going to be a few names that bite you.

The sooner you accept this reality, the better. If you beat yourself up about the one or two stocks that didn’t work out, you’ll drive yourself mad.

The goal cannot be to completely eradicate losses. This just isn’t possible in the market, as there are too many variables at play in global commerce. Instead, the goal should be to minimise losses by cutting as many avoidable losses out of your process as possible.

For those who enjoy watching tennis, these are the unforced errors that players work so hard to reduce. If the market serves an ace right past you, or hits a spectacular winner down the line, these are just the realities of getting on the court against a good player. But if you hit an easy shot into the net, you’re not really giving yourself a chance.

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People do this with their portfolios all the time.

Avoidable losses

There are a few factors that tend to be at the root of most avoidable losses. Let’s dig into them.

The first is the decision to jump on the hype train. It isn’t just market newbies who are at risk here – even the most experienced professionals are really good at convincing themselves that ‘this time, it’s different’.

Time and time again, markets dish up new technologies or ideas that seem to be a guaranteed way to make all the money in the world. In these hype cycles, the smart money gets in early and gets out in time. As for everyone else, it’s a nasty experience that teaches a real-world lesson about market bubbles.

As I mentioned earlier, nothing is ever all good. When markets have lost their minds and nobody is talking about the risks of a downward move anymore, it’s likely that a downward move is just around the corner.

But when does this become a permanent loss of capital, rather than just a sell-off and an example of heightened volatility?

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Those who bought the hype and sold the crash would likely be locking in a decrease of 30% – or more – in their capital. The mistake here was to buy so high that the resultant sell-off is just too much to bear.

With neither the financial muscle nor the emotional capacity to buy that dip, even if that might be the right thing to do, getting on the wrong side of a hype bubble can put an investor off the markets forever. It really is dangerous.

The second element of avoidable losses that I want to touch on is the danger of poor research.

It’s easy to feel great when stocks are going the right way. It becomes a dark place when they go the wrong way.

If your position was informed by a hot tip or something you read on the internet, instead of through your own research, then you’ll be left confused and angry by a sell-off.

You won’t know whether you should buy more shares, or cut your losses and run away. You won’t know anything, really, because you didn’t do the work.

If you’re going to invest in single stocks, you need to develop a skill set around macroeconomic factors, valuation methodologies and bull versus bear cases. You need to go through the process of doing the research and getting a reasonable understanding of how this stuff works.

This will help you steer clear of a lot of really damaging avoidable losses, as you’ll stand a much better chance of distinguishing between a temporary sell-off and a permanent downward trend.

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The third source of avoidable losses is lack of diversification.

If you have a well-constructed portfolio that lets you sleep at night, you’ll successfully ride the volatility more often than not.

You won’t panic about the stocks that do badly, nor will you be tempted to cut your best performers due to concentration risk.

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A further benefit to this approach is that you’ll avoid the friction costs in the market. Trading fees aren’t the end of the world, but triggering tax events by selling your winners means that you’re losing part of your capital to tax.

Tax is going to be payable eventually, but pushing it out to a later date means that you get the benefit of your capital compounding for a longer period.

These are just a few examples of avoidable losses. There are obviously many ways to make mistakes in the market. Trying to minimise these mistakes is a really worthwhile exercise.

Diversify, read and stay humble

The markets are exciting. They reward good behaviour and punish bad behaviour. They turn paupers into kings, and sometimes kings into paupers.

Through all the noise, there are certain approaches that are almost always a good idea.

Be reasonably diversified and read as widely as possible – examples of good ideas – as you simply cannot rely on others to do all your research for you.

And perhaps above all else: stay humble in the markets.

If you haven’t been taught a hard lesson yet, then that experience is almost certainly still coming your way.

The ones who create incredible wealth over several decades are those who learn from these experiences and commit themselves to a process of continuous improvement and lifelong learning.

We are all still learning. Thank you for learning with me over the past couple of years. I wish you all the very best in your investment journey.

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