Warren Buffett has blessed us with a succinct, if not a smug, little guideline for investing: “the first rule is not to lose. The second rule is not to forget the first rule.” On the basis of this observation, you might as well leave your cash stew in the bank. But the problem with money in the bank is that the return is so paltry, you’ll probably violate Buffett’s first rule of investing over the long haul. Your savings will most certainly be eroded over time by inflation.
On the other hand, if you impulsively chase wild opportunities in stocks or commodities in the hope of spectacular returns, you stand to lose because your hopes and wishes will mask and then outpace your better judgment.
These polar opposites in the styles of handling money prompt questions about risk. Is risk a good idea? If so, how much risk is appropriate in your portfolio? And how do you go about taking risk so that you don’t lose money?
Financial gurus and commentators don’t agree on the answers. And if you cling to the extreme of either side of the argument, it’s easy to prove your point. One has only to phone a local bank and understand the problem with taking no risk and putting all your money in an FDI-insured savings account (a so-called “safe place”).
Let’s take a look at a style of investing that entails intense risk – investing in momentum stocks. A momentum stock is one that has been flying high in the last three-twelve months. An investor will throw himself into a momentum stock in the hope he’ll ride a whirlwind to quick profits. Unlike the value investor, the momentum stock investor is not necessarily concerned with the underlying strength of the company. He’s more interested in the public perception of the stock, and therefore how well it performs, over a relatively short period of time.
In an article for Forbes back in April, market commentator Tom Aspray discusses the stock Chipotle Mexican Grill, Inc (CMG on NYSE): The stock “hit a low of $233.82 in October 2012, and by the March 2014 high of $622.90, it had gained 166%.”
Sounds great, doesn’t it. But Aspray, a careful adviser and technician, advises against investing in Chipotle Grill. Here’s his reasoning: “This meteoric rise made it a favorite of traders but those on the long side have been punished over the past six weeks.” Aspray goes on to observe: “With Monday’s close at $506.54, CMG is now down 18.7% from its March high.”
Aspray is simply trying to be rational and responsible. And he cites some technical reasons too for avoiding stocks like CMG altogether.
What’s fascinating about this entire discussion is that Aspray’s article appeared on April 22, 2014. He shows how investors would be down on their money at that date from the stock’s March high. But suppose those same investors stayed in CMG. Today’s market close for the stock tallied in at $672.50 – hardly a loss for those who were in the stock since it had hit a bottom of $233.80.
But there is no perfect way to deal with risk. Aspray’s warning to stay away from momentum stocks is probably wise for an 80-year-old looking to preserve his capital. But for a younger investor who has the time to watch the market every day and the technical chops to understand what’s happening, a certain level of risk might prove profitable.
Also there are ways to manage your risk. You can mix your portfolio with less volatile stocks or with bonds or gold. You can hedge your risk with options – you can buy puts on the stocks you buy on the long side. That way if the stock price declines, you’ll make money on your puts. Or if you want to make money in the markets without the huge ups and downs of momentum stocks, you might want to consider buying index funds. You won’t experience the giddy returns of a skilled momentum stock investor, but you’ll stay ahead of the meager rate of return of a savings bank.
The important thing to remember is that investment risk is not an either-or proposition; it represents a continuum of possibilities for gains or losses.