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 biasness 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 overweighs 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.

Ah, yes, its exactly like my favourite postings before back in 2006: Our Eyes Seeing What We Want to See

Let me reproduce here again.

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In the Show Me the Money column, Ms. Teh Hooi Ling, wrote an incredibly interesting piece titled "Meeting management a waste of time?".

The article was based on James Montier's 100-page report on the seven sins of fund management last year, the third sin is: Why waste time listening to company management?

Here is what she wrote. My comments will be in purple.

==>>

He puts forth a number of reasons why he thinks talking to management does not help investors make better investment decisions.

First, managers are just as biased as the rest of us, he says. He quotes the Duke Survey of chief financial officers in support of this claim. The survey is carried out every quarter and covers around 500 of America's major companies. The average company has sales of US$2.3 billion and half are listed.

One of the questions the CFOs are asked is how optimistic they are on the economy and on their own companies. According to Mr Montier, in every case, managers were more optimistic about their own company than they were about the economy as a whole. 'This is a classic case of illusion of control driving overconfidence,' Mr Montier says. (How true isn't it? Let's not talk about these officers. Talk to the owners of any local listed stocks. Asked them about their share and they would always give their utmost optimistic views. Would one call it bias? Or is this just pure natural human behavior? )

In the earlier days of the Duke survey, CFOs were asked if they thought their stock was undervalued by the market. On average 63 per cent thought so, while 32 per cent thought their stocks were correctly valued. And - get this: At the peak of the Internet bubble, nearly 90 per cent of CFOs of tech companies were of the opinion that their stocks were undervalued. ( Even investors. People like you and me. if anyone asks us about the current potential of our stocks in the current optimistic market, surely we would give a slightly biased optmistic views of our stocks right? )

The problem does not just lie with the corporate managers. It's with us as well. Human beings have a tendency to look only for information that happens to back up their current view. Not only do we look for information that agrees with our belief, we also pretty much see all information as consistent with our prior beliefs. (We had a chat at http://sahamas.net/ with fellow blogger JamesBull regarding the dangers of reading too much into 'news media' where one could fall into the danger of our eyes seeing what we want to see syndrom. How true isn't it? )

.. Ms. Teh then continues....

'This is the power of authority ... the more god-like the management, the easier it will be for them to influence analysts who cover the stocks,' says Mr Montier.

After having to watch out for our own psychological flaws, there is still one more hurdle. Can you tell the truth from a lie?

If management is intent on lying to you, can you tell?

(hmmm..... extremely interesting point isn't it?)

In another experiment, students were given training in the most common methods of deception detection. The findings: confidence increased with training and experience but accuracy did not.

Indeed a friend who has abundant dealings with top management of companies said she has been 'smoked many times before' and that despite her experience, she has yet to master the skill of telling whether someone is telling the truth.

So where does this leave us?

'Given that we can't easily correct these biases, perhaps company meetings are best avoided,' says Mr Montier.

(Yeah so where does this leave us?? How, Brown Cow?)

here is Ms. Teh's opinion...

Well, I still believe there is value in meeting management.

For one thing, you can understand from a manager the industry his company is in. Then you listen to his strategy and what he plans to do as part of his strategy. From there, you can then critically assess if you think the strategy is workable in the context of the industry and what competitors are doing.

And I believe that one can get 'vibes' - be they positive or negative - from a person through face-to-face interactions. Your life experiences will tell you if you are a good judge of character or not. Of course nobody can be 100 per cent right about a person 100 per cent of the time. But if you are right 80 per cent of the time, that's already not a waste of time.

So perhaps based on the biases mentioned above, someone who is very grounded and not carried away by how smart or good he or she is, someone who has great intellect and a little - but not too much - cynicism, someone who has a little rebellious streak, someone who is able to pick up only the relevant information, someone who has an open mind, and someone who is a good judge of character would make a good analyst.

That's a tall order, and chances are if a person has all the above qualities, he or she wouldn't be recognised as a 'good analyst' in the market. He wouldn't believe that he is able to see the future better than others, and would not be confident enough to have a 'buy' call with a target of $3 with the stock at 50 cents. And without such bold calls, the broking firm that employs him cannot earn commissions, and he will soon be out of job.

Perhaps he might be able to do better in a traditional or hedge fund or managing his own money.

(Me? I tend to agree with Ms.Teh here. The danger of seeing what our eyes want to see will persist in every situation, in regardless if we meet the management or not. The danger exist when we read the news article, believing what we want to believe. The danger also exist when we read a recommendation from an investment house which has a good track record. (Reasoning here is a fund manager with an excellent track record might not necessarily give one a honest investment advice). This is why sound reasoning is so very important. Sound reasoning should remove this biasness issue.)

Ms. Teh then concludes her article by stating the following...

Meanwhile, Mr Montier's other six sins of fund management are:

• Our insistence on relying on forecasts when it has been proved time and again that we simply cannot forecast.
• The illusion that more information is better information.
• Thinking that you can outsmart everyone.
• Being short-term focused.
• Believing everything you read.
• Believing that group decision-making is better.

So ultimately, if one were to start questioning everything - what management says, that one's own forecast cannot be trusted and that one cannot outsmart others - then the only logical investment choice would be to buy into an index, which incidentally is a good option.

As for the stock pickers among us, the list then acts as a reminder to constantly check against our own biases.

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And for me? I do hope I do not fall in the trap of being too bias towards the concerns and risks of any given stock!

Just a reminder for myself.