A few words on ‘fear’ and ‘risk’

I’ve been in a bit negligent on the CM blog front lately with a host of other projects on the go including child minding, travel, development of another one of my businesses and embryonic planning for the purchase of some land and the construction of a low-cost, low-energy sustainable house. A new blog should follow soon where I will write about these projects.

 

Today’s CM post continues a theme I’ve covered in The Child Millionaire ebook and elsewhere on this blog, which are the twin sides of the investment coin: fear and risk.

 

My last post was 8 December 2011. In the meantime lots and not much has happened in the stock markets, which illustrates a few key points about fear and risk.

 

On 8 Dec 2011, the FTSE 100 stood at 5483 on the cusp of a multi-month rally that saw it hit a high of 5965 on 16 March before slumping back down to 5260 on 1 June and then creeping higher to about 5600 today.

 

What jerked the FTSE and all other major stock markets around over the past six months were twists and turns in US jobs reports, the woes of Greek elections, bond rate spikes in Portugal and Spain, French elections, Spanish bank bailouts, more Greek elections and more Spanish pain along with monetary juicing here and there by central banks, markets clamouring for more cash injections like back alley junkies and looming over everything the twin prongs of a euro zone on the edge of disintegration and the US presidential race.

 

Yet an investor with a very long term horizon who had simply gone to sleep for the past six months [much like I metaphorically did] would see that not much has really changed. Dividend paying giants with rising dividends continue to pump out the cash and with each reinvested dividend the size of our holdings increase which compounds our capital by spawning larger future dividend payouts that are also reinvested in an ongoing cycle.

 

So what about fear and risk? Simply put anyone who paid attention to the news over the past six months [something I don’t recommend doing] would have seen a world apparently awash in fear and risk. Yet this is because risk is woefully misunderstood by the average investor, which partially explains why fear takes over and small investors tend to do poorly in the long run.

 

Most people have risk completely backwards. Most would see the FTSE 100 dropping by 12% in two-and-a half months to 5260 on 1 June as ‘risk’ in action – i.e. the value of your invested capital diminishing. What this means is that most people trip over each other to sell when the market is dropping, fearing that it will never stop dropping. Yet these same people can’t wait to pile in when the market is spiking upwards for the fear of missing out on big gains.

 

What we should be doing with our Child Millionaire portfolio is the exact opposite. When the market drops, risk is actually being squeezed out as the probability and size of further declines diminishes and high yields put a floor under the market of high quality shares. As the share price of our favourite Dividend Aristocrats get pulled down with the overall market, regardless of the performance of the businesses themselves, the yield [dividend / share price] increases and we get more shares for our money. Simply put, when the market drops you should be backing up the truck to load up on your favourite Dividend Aristocrats. Risk has been squeezed out; the shares are on sale and the yield, and thus your return over time, increases.

 

Correspondingly, when the stock market is flying high and Dividend Aristocrats get pulled upwards, risk increases both in terms of the probability and size of future capital declines but also because you get fewer shares for your money and the yield on these shares, and thus your future return, is lower.

 

So contrary to what you might think and what the media churns out, a dropping market indicates risk is dropping and a rising market indicates risk is increasing.

 

Buying when everyone else is selling is contrarian and it’s smart and it works. But it’s also hard because it requires you to conquer fear, which is a powerful human emotion peddled relentlessly by the media. As social animals we want to do what everyone else is doing, which explains most asset bubbles and why average people buy at the top and sell at the bottom be it stocks or houses or tulip bulbs. Yet we need to do the opposite.

 

The most practical way to do this is through automatic regular investments that take advantage of pound/dollar cost averaging. Or for those elusive, stoic individuals of Spartan discipline who can cultivate what I’ve referred to as ‘strategic ignorance,’ a well-structured and executed investment plan built on the patience to wait for low share prices and the conviction that the world is not coming to an end. It’s the rare person with this discipline, which is why most of us are better off following the automatic regular contribution approach.

 

So you need to get it into your head: when markets drop, risk is being squeezed out and it’s time to buy, when markets rise, chill out, buy less and plan what you will buy during the next drop.

 

Or as Baron Rothschild bluntly put it: ‘buy when blood is running in the streets.’

 

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