When it comes to managing risk, investors need to manage their expectations. Be realistic about the outcome you expect from an investment, and understand the consequences of this outcome not materialising.
As traders or investors, we are essentially managing risk and, typically, we focus on the risk of losing money. But risk in the markets is about far more than just losing money. I have written before that one of the great things about investing is that your downside risk is capped at 100%, as an investment can only go to zero. But the reward is unlimited, as a share’s price can rise to absolutely dizzying heights. If we keep this in mind, investing becomes much easier – even if there are a few dud shares along the way.
However, there is a lot more to investing than this – and there are risks beyond losing money. Nerina Visser, director at etfSA, once commented that risk is when the outcome is not as expected. This fundamentally changed how I view risk with my own investments.
One way to view this is that an exchange-traded fund (ETF) carries no risk if you buy it with the expectation that the ETF will merely return the underlying index return. This is how an ETF is designed and if you’re happy that indices bounce around and that the ETF will track this movement, then the expectation will meet the return and the risk is removed.
But, for an active investor, what of a scenario where you buy a share expecting it to double in value, but it only goes upby 50%? This is still great but is not what you expected; the risk here being that the return was lower than expected. Instead of being happy about the 50% return, you’ll consider it a failed investment because the share price didn’t double.
Looking at risk in this way – based on the outcome not meeting expectations – is far broader and more useful for investors. For example, consider the expectation that you will get a certain return from your investments over your investing lifetime to leave you comfortable in retirement. If the returns are lower (even if positive), and don’t meet your expectations, this results in a lesser retirement.
In the case of retirement, life expectancy is another expectation risk to consider – living longer could mean that you won’t have enough money for your retirement.
The lesson for investors is to take note of our expectations. Sure, we’re buying stocks because we want a profit and, truthfully, a profit that over time beats our benchmark – the market. But we also need to be realistic with our expectations – both in that we may be wrong and make a loss, but also in what the upside potential is. Expecting that every stock we buy will be a ten-bagger in double-quick time is a massive risk because you’ll find that few stocks are ten-baggers.
One way to manage this is, of course, realistic expectations and an acceptance that we may underperform these expectations.
Is it a growing market that will benefit the business, or perhaps pricing power that will see prices and hence margins and profits increase? Another avenue for a share price increase is a rerating higher for the stock. It may be trading on, say, a price-to-earnings multiple of ten times, but we expect that to increase to 15 times and just this rerating will increase the price some 50% without margin or market share gains.
But here a word of caution, as we run into exactly the same risk: an expectation that the market will rerate the stock higher. What will drive this rerating and what if our expectation is not met?
So, be very aware of your expectations. Are they realistic? And what’s the impact if they fail to materialise?