VALUE INVESTING
How Much Risk?

By Stephen Bland (TMFPyad)
November 3, 2000

I can't find any worthwhile shares to write about this week so here's a bit of a ramble on risk.

Say two people each double their money on different shares. Both are value plays with similar fundies, the primary difference being that one is a large cap and one is a very small cap.

As I have often written, I personally do not invest in small caps because I perceive them, for various reasons that I have mentioned, as being inherently more risky. Even though they perhaps possess all the finest value features, I turn them down merely because they are small caps.

But after the event though both our investors have made exactly the same return. Does it then matter how they made it? Is money just money, regardless?

Risky or risk-free?

Put that aside for one moment and consider this. Value investing is essentially a short(ish) term strategy the way I play it. In general I will rarely hold a share for more than around two years. By then, in most cases either I will have made money or I will have decided that I am not going to, perhaps because of a deterioration in the fundies or whatever reason.

Now in order to make decent money in the long run, out of a series of short term plays, it is apparent that enough of them have to work to produce a good return, even though there will be the odd poor investment. In my view there is little point in playing this particular game unless you want to achieve something like 20%+ per year. Since the odd one will go wrong, and there will be fallow periods when your money is just sitting in the bank earning interest, it follows that the successful shares have to be very successful. Think about 33% profits at least on individual plays if you want to average 20%+ per year.

Two things need to happen to achieve this sort of outstanding result.

Firstly, and to my mind foremost, you have to cut down on the losers. Minimise the downside as I repeatedly tell people until their eyes glaze over. I cant stress this too much. Look at a lot of portfolio players. Typically they will have one or two good investments, a number of mediocre ones and some duds. This trashes overall performance. What 'value' offers is a way to rid yourself of the duds and mediocrities.

Secondly of course you have to learn to be good at finding the winners and they have to be good winners, with fat profit potential.

Create a strategy

Back to the origin of this feature then. If like me you believe that, for example small caps carry higher risk than large caps, it follows that someone who repeatedly invests in small caps will have more failures than a large cap investor. It could of course be argued that small caps, when they work, offer more profit potential than large ones. Maybe they do sometimes but I still see them as greater risk without there being a sufficiently attractive reward.

So two people doubling their money, one on a small cap and one on a large cap have at that point done exactly the same with their investment. But dedicated repetition is essential to making long term profits. It is in sticking to, and repeating with discipline, a successful approach that serious money can be made by reinvesting the profits each time. Because the risk is higher with small caps, the repeat success rate will probably be lower in the end, even though it is on occasion sometimes the same or higher than the large cap player.

I am just using the small cap/large cap comparison as an example by the way. Many investors may not agree that small caps are more risky. My point though is to examine in general the making of the same amount of money out of a lower risk investment compared with a higher risk one and how this is affected by the crucial repetition required to make long term high returns.

Risk adjusted return

I think many investors do not see this point often. It is called risk adjusted return. Some people may have made large profits from the tech boom a while back, just as an example. Some of them may in consequence think that it is easy to make money from the market in this way. In fact though they may have been running massive risks and won through by luck. Such investors will not be able to repeat this trick over and over, covering many years. Or if they can then they are skilled traders but I am not referring to that latter type.

The real skill of an investor shows through by repeatedly making good profits, even with the odd loss, over a long period. Thus it can be very misleading for novice investors to see possibly very high profits being made on one particular thing, and then think that they appear to have discovered some great strategy, without considering what risks were taken to achieve it. If those risks were very high, then it is pretty likely that what you are looking at is not likely to be a repeatedly successful strategy but an isolated win. It follows that by repeating this, you are far more likely to lose with it in the long run than succeed.

The ideal combination is the lowest risk against the highest reward. That stands the best chance of being repeatable. And as an odds player, that is why I so rarely find good shares to buy. Most dont offer the likelihood of large returns, combined with the security of low risk. In fact such a perfect combination shouldnt even exist in theory. Traditionally high rewards go hand in hand with high risks, and generally that is true.

But I am looking for the ungeneral, which the inefficient market throws our way sometimes.

Where next?

• Value Shares discussion board
• What is a pyad value share?