Lesson 007 – Investment Risks: Montana!
A group of prisoners is bored to death already: they discussed all the topics possible, told all the jokes they knew and played all the card games they knew. They don’t know how to entertain themselves. So, when a newbie enters the cell, they ask: “What card games do you know?” The new guy says: “Well, I know poker, preferans, whist, ombre, montana…” Everybody is curious about this new game, montana, so they say: “Let’s play montana!” The newbie say: “Okay, the game is so simple that you will get the rules down the road. Let’s start!”
So, the deck is shuffled, and each player receives six cards. Our hero gets up, throws his cards on the table and says: “Montana! I won.” And takes all the money. Everybody looks adverse and puzzled, so he explains: “Whoever gets up first, says “Montana” and throws his card on a table, wins. Very simple.”
Everybody grins and offers to play again. The new guy is shuffling the deck again and is handing over 6 cards to each player. While he is doing this, everybody who just got cards, gets up, throws the cards on the table and says: “Montana!” Our hero is the last to take his cards. He waits till the last one throws the cards and says “Montana!” Then he slowly puts his cards on the table, and says: “Trump montana! I won again.” And takes all the money…
(An old-old joke)
In fact many people repeat the same mistake when it comes to investing: they don’t know about trump Montana! In this article we are going to discuss the most remarkable risks you definitely will face investing. First we will list the most important risks. Last and foremost – we will discuss how to mitigate them.
Pretty much everybody knows about this risk. It is the most obvious one: if you invest in stocks or mutual funds, be ready that if the whole market drops, your investment will highly likely drop too.
The most important question here is: how much will the drop of the market affect my investment? The answer for each particular publicly traded company is in its beta. For example, the Beta for MCD at the moment of writing is 0.64768:
It means that if the market drops today by 1%, McDonald’s will drop accordingly by 0.64768%.
Such a risk is called systemic: it affects the whole system, i.e. entire market or financial system. There are also non-systemic risks – they affect particular companies or industries.
Foreign Currency Risk
Let’s assume you bought OGZPY – shares of Gazprom, russian gas giant, back in 2013. All the profits Gazprom makes are in Russian rubles. Because of the sanctions against Russia and other factors, the value of Russian currency has chopped in half. So, even though they can report even some growth, the dividends you are going to receive today will be negatively affected by RUB-to-USD conversion rate.
NOTE: to be more precise, OGZPY are not technically shares of Gazprom itself, it is an ADR.
This risk is also known as Foreign Exchange Risk, or FX Risk, or Exchange Rate Risk, or just Currency Risk.
Interest rate risk
What happens if you buy stocks today, and tomorrow FED will increase interest rate?
To answer this question let’s look at what happens in the financial system. If interest rate grows, any financing becomes more expensive (both for people and organizations). So, everyone’s access to “cheap” money decreases. Many companies depend on these financing in their operations. So, less cheap money for them means shrinking of their business. Plus, of course, their clients are now short of money too. Thus, their earnings will go down. Obviously, less profitable business costs less. So, in general, stock market will go down. So do your shares.
At the same time, bank deposits become more attractive: they now will generate more interest.
Corporate bonds and government bonds will react to growing interest rate differently: corporate bonds will go down (the same reason as for stocks), but government-issued bonds will go up (in a way, they will behave same as bank deposits).
IMPORTANT! When you make any investment (stock or bonds purchase, bank deposit etc.) you must be aware of this risk: what happens if interest rate changes. This is another example of systemic risk.
Problem #12: What happens to all above mentioned investments if Fed decreases the interest rate?
And one more thing: bear in mind, that this risk can affect your investments directly (when it affects their market price, as we described above) and indirectly (when you already locked down your money and cannot switch to another, more profitable investment right now).
The name of the risk speaks for itself: something affects the whole industry as opposed to single companies. Examples: price of gold affects the whole gold mining industry; recent turmoil with oil prices affected several industries related to oil; a disruptive innovation like Square-Up can theoretically affect not just Mastercard or Visa, but the whole credit card processing industry etc.
There is always a possibility that a company will have lower than anticipated profits or even experience an
unexpected loss. This risk is driven by enormous amount of contributing factors like competition, change of input costs, lawsuits against the company, bad entrepreneurship, some unusual circumstances affecting sales (for example, an unusually cold summer affects the sales of soda pops and ice-cream, it also affects the consumption of electricity etc.) and so on.
How to mitigate this risk? Diversify! By the way, this is a non-systemic (or unsystematic, or “diversifiable”) risk.
MMI stands for “Me, Myself and I”. In many realms your worst enemy is you. Investing is one of such realms. This refers to lack of knowledge, cognitive dissonance (when you continue doing something wrong, because you afraid to admit a mistake), over-excitement (when you buy something just following the hype and frenzy or when you make a stupid speculative decision), lack of patience and so on.
How to fix this? Just learn on your mistakes, be forgiving to yourself, every time explain to yourself what for you are going to do this or that, and refer to other people’s opinion (not necessarily experts or mentors, I ask my wife from time to time).
This risk can affect “gentlemen who prefer bonds”. Callable bonds. Or debentures. Say, you bought a debenture which matures in 2049 and has a face value of $100. The price you paid was $115. And you forgot to look at its Call Date (which was, say, in 2014). Now there is a risk that the issuer will redeem them (call) before they mature – at any moment starting Call Date, i.e. even today. If it happens, you will get back just a face value, so, your loss will be $115 – $100 = $15.
And trust me, any issuer of callable bonds or debentures will do that as soon as maintaining them becomes too expensive!
How to avoid that? Look through the prospectus and find this information before making decision to buy.
Though this list of risks is not exhaustive, I tried to compose it from the most interesting and practical gotchas an individual investor can face. The risks here are systemic or related to the particular industry or company.
The most important thought about managing risks is this:
In theory you can protect your investments from any risk (in more details we are going to discuss hedging risks later, in other article). But, almost always, the cost of eliminating 100% of risk will be that high, that it will equally downplay your return. So, you have to accept a certain degree of risk.
And now let’s sum up some measures to minimize the aforementioned risks:
- Form your portfolio according to your risk tolerance;
- Don’t be too aggressive;
- Read prospectus;
- Know what you are buying and deal with only what you understand;
- Make sure that the business behind equities is fundamentally strong;
- Keep an eye on the state of things within industry, not just a company;
- Learn on your mistakes.