Wednesday, March 19, 2008

Realistic Risks of Long Term Stock Investments

Long investment positions of corporate common stocks carry inherent risks. Advisers, agents like to avoid this subject as it requires more profound considerations via the client investor, and understanding it would reveal the often unjustified entry-costs and management fees.

Risk of General Market Downturn

The stock markets have a positive correlation to general economic swings, and wield at least a couple of bearish years each decade. This leaves the probability of stock markets ending each year at higher levels of 70-80% at best. The industry analysts, advisers or brokers facilitate public ignorance of this easily in bullish periods, where any stock seems to rally effortlessly with the illusion that no forms of risk exist.

Realistically, just the opposite is true. The longer a certain stock has rallied continuously, the more likely institutional holders look to take profit (i.e. sell) before the bearish period commences, or perhaps they know something that the public does not. Of course they need chumps to provide liquidity and buy off them, the role usually played by the general public; this is where the financial advisers and brokers do their magic and sell the “risk-free” sentiment, where “Of course it’ll go up!”

Risk of General Volatility Even In Bullish Periods

Prices do not move in nice smoothed curves, but rather ugly zigzags as result of constant quasi-auction based trading on the exchange floors. Even in a bull market, the general fluctuations occur and the simple attitude of ignoring this risk and “focus on the far horizon” typically ends in mediocre or terrible performance.

Accurate assessment of potential loss due to volatility could require a lot of number crunching, but simple methods exist as well. The ATR, or Average True Range, for the historical annual price ranges provides a rough estimate. Most of the free web based price charting services provide this one of many available volatility indicators.

Risk of Corporate Bankruptcy

Stocks from Enron or WorldCom had performed well in the bull market of the 90’s, and their demise never appeared obvious until the selling began. This risk always exists in long term long side stock investments, and it increases with length of holding period.

In other words, longer held stock positions carry higher risk of losing close to 100% of the associated value according to historical statistics. Longer held short positions face higher risk of getting squeezed short, i.e. the original lender of the shares demand them back, but even that has a lower loss potential than the upside bets.

Consistent Investment Profit Takes Work

Solutions exist to mitigate or limit the above mentioned risks. Taking short positions, applying market-neutral strategies, arbitrage schemes are some of the many options available to the retail investors. Investment managers who does not acknowledge or disclose these issues imply incompetence or dishonesty, and probably do not deserve the hefty fees.

It takes dedicated self-education, then planning and flawless execution to win in this game. Like many other good things in life, complex, but not impossible. I will discuss some of these solutions in a future article.

1 Reflections:

Anonymous said...

To minimize risk do three things
1. buy quality equities
2.Buy them cheap
If these tenants are followed your chance of failure are slim for the only way to fail would be if an entire society fails.