Defining Risk Characteristics

Risk in Investing

Volatility of share prices of rapidly growing enterprises is an acceptable risk for long-term investors (after liquidity needs are satisfied, of course). Relative volatility expresses risk in only very partial terms, which says too little about enterprise risk to be very useful, and says nothing about how rapidly a young, vigorous enterprise is outgrowing relative hyper-volatility.

Within the limits of the tolerance and disposition of a client, selections toward both ends of the risk spectrum — defined as extending from high quality bonds to the shares of young, and still tender, enterprises — generally give greater returns for total risk incurred than that obtainable from a mix drawn from the center of the stock market. Well-known companies commonly are overpriced after long periods of bull markets, delivering to the owners a substantial degree of market risk. Thus, investors would be unduly exposed to sharp downside price adjustments or to stagnation for years.

Weighting a portfolio at both ends of the risk spectrum is sometimes referred to as creating a “dumbbell balance”. The dumbbell assists the weightlifter in balancing with the advantage of mechanical leverage. In the event the sheer weight (of the market) becomes overwhelming, there is protection in having weights at the extreme ends of risk, just as there is for a weightlifter in the event he falls. For investors as well as for weightlifters, the dumbbell is a very economic use of form and weight. In contrast, if one owns only center-of-the-market shares, there is little or no avoidance of the consequences of a market drop.

By and large, the center of the market returns good results only in bull market phases. The overlooked corners of the market and undervalued rapidly growing young companies often give attractive reward/risk ratios after a long bull market phase.

It must be acknowledged that an uncommon selection of shares might be directly associated with volatility, for, if shares are uncommonly recognized, their market liquidity will be circumscribed thereby. However, uncommon selections do not necessarily entail most other forms of risk. The lack of familiarity is more likely to lead to attractive pricing, and less fundamental risk to the long-term investor.

Take comfort in owning shares that few people know about. As these shares come into broader recognition, the price will likely improve, giving the first stage of gain. If the selection were right in the first place, there will also be the pull of earnings as a gain. That combination is likely to eventuate in an excessive valuation, especially if a market is supported with a wealth of liquidity. Selling early and rejuvenating the portfolio mix by purchasing companies that are still unrecognized is one of the best means of controlling risk and enlarging rates of return.



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