No Risk No Gain But Risking Too Much To Gain Too Little Makes No Sense Either!

Peter Bernstein has published a wonderful piece of article on New York Times a couple of weeks ago, What Happens if We’re Wrong?. It was featured by Chris Puplava, FinancialSense's market commentator, on his wonderful market wrap today, Don't Forget Newton's First Law!

• What Happens if We’re Wrong?
  
  “The key word is ‘consequences.’ I learned this lesson many years ago from studying Blaise Pascal, a French mathematical genius in the 17th century who spelled out the laws of probability more clearly than anyone before him. This was a thunderclap of an insight that, for the first time, gave humanity a systematic way of thinking about the future.
  
  Pascal was both a gambler and a religious zealot. One day he asked himself how he would handle a bet on whether ‘God is or God is not.’ Reason could not answer. But, he said, we can choose between acting as though God is or acting as though God is not.
  
  Suppose we bet that God is, and we lead a life of virtue and abstinence, and then the day of reckoning comes and we discover that there is no God. Well, life was still tolerable even if less fun than we might have liked. Here, the consequences of being wrong would be acceptable to most people.
  
  Suppose, however, we bet that God is not, and lead a life of lust and sin, and then it turns out that God is. Now being wrong has put us into big trouble.”
  
  “RISK management, then, should be a process of dealing with the consequences of being wrong. Sometimes, these consequences are minimal — encountering rain after leaving home without an umbrella, for example. But betting the ranch on the assumption that home prices can only go up should tell you the consequences would be much more than minimal if home prices started to fall.”

The key assumption here is ONLY.

And Bernstein then continues by explaining the issue of risk management.

• In this assumption, the word “only” is ridiculous. There are no “onlys” in the future. More things can happen than will happen.
  
  Under those conditions, risk management should concentrate either on limiting the size of the bet or on finding ways to hedge the bet so you are not wiped out if you take the wrong side — if home prices do start to go down, or even stop rising. Risk management is fundamentally different from managing volatility, which is how many investors view it. Volatility is often a symptom of risk but is not a risk in and of itself. Volatility obscures the future but does not necessarily determine the future.
  
  Effective risk management starts with the recognition that any forecast can be wrong, then weighs the consequences of being wrong. Only then can we decide whether to make a bet, whether to hedge that bet and how to execute the hedge if needed. ( Do read rest of Bernstien article here )

A couple of months ago, I wrote Understanding My Investment Risks.

• Investing in any stock(s) is risky.
  
  There is no investment which carries absolutely zero risk.
  
  Which is why before I make any investment decisions, I always, always weigh out all the pros and cons.
  
  Investment should never be about investing based on yardsticks and numbers. As mentioned before a low PE stock does not the stock a good stock. It simply means that the stock is traded cheaply in comparison to its earnings.
  
  Do you see that it is so common that most tend to equate a LOW PE stock as a great investment? And the whole bias-ness is based on the fact that it's a lowly traded PER stock.
  
  Which I feel it's so badly twisted.
  
  One should invest in a GOOD QUALITY stock that a cheap price. However, it does not mean that all cheap stocks are GOOD QUALITY stocks. Some stocks are cheap because of the risk within the stock. You cannot use the cheapness in the traded stock price to justify that the stock is good!
  
  Too confusing?
  
  Flip it the other way around.
  
  How about them high PE stocks? Does a high PE stock make the stock a lousy stock? Does it? I don't think so. It only means that it's an expensive stock and from an investing perspective it only means that our chances of being rewarded in such an investment is rather slim. ( Dali had also written recently on PER and here is his take, PER – simple but limited )
  
  Anyway, back to the pros and cons of the stock.
  
  And because I tend to consider all the concerns and risks within a stock, folks tend to consider myself a critical cynic.
  
  But my reasoning is simple, if we don't know and we don't consider all the risks and concerns within a stock, how can we fully justify the risk in our investments?
  
  Should the fact that the stock trades at a low PE over weighs all risks?
  
  Well, if that's the mindset, then I have one great example, Megan Media. It showed clearly the risk when one gets fixated on the investment yardsticks and ignores all the risk.
  
  Understanding the business model and the economics of the business is so very important, yes?
  
  What's the driving factor that's driving the current earnings? Could this driving factor be sustainable? Is it cyclical? These are issues that need to be considered, yes?
  
  And about management issue?
  
  If ever you doubt the management or the owners of the business, how could one invest in the company?
  
  Take HaiO case. Back in 2003, it declared to the press it was cash rich and debt free but when one digs further, one discovers that the cash free is derived from a recent rights issue!
  
  So in this given example, won't you doubt this management?
  
  In real life, say you meet this crazy bugger and he asks you to be his business partner in a barnyard business. But this bugger is sort of a whacko because he tends to go bonkers and whacky in the afternoons. Too much smokes I guess. So in such a situation, surely you have your doubts, right? And common sense should suggest to you to forgo this barnyard business opportunity.
  
  Perhaps my example is not the best but shouldn't one have the same type of mindset as an investor? When one have doubts about the management of a company, why should one invest in the company then? Aren't we ignoring our investment risk?
  
  Of course when we get to adversely focused on the risk, one can miss some winners.
  
  Firstly, missing out on a winner is no crime but losing money because one ignores the risk is a crime for me.
  
  For example, take the stock VADS. It was a stock market winner but I chose to ignore it because I simply could not comprehend the risk involved in investing in the stock. VADS is a stock in which its majority shareholder is also the main and only customer for the business. Such a model simply did not make sense to me. Hence, from an investing perspective, I had chosen to give it a pass.
  
  Remember missing out on a winner is never ever a crime.
  
  But some form of greed is always within every one of us and greed can play tricks on our mind. Sometimes we only focus too much on the pros of a stock investment. One only sees the opportunity within the stock and dismisses all possible risks.

And again for now I would like to remind myself to NOT fall in the trap of being too bias towards the concerns and risks of any given stock and the current market too!

Yes no risk no gain but risking too much to gain too little makes no sense either!