Risk: The Necessary Evil of Stock Investing

It was another down day at the exchanges. At the close, the Dow had slipped -241 points and the NASDAQ was off -2.0% as well. Stocks fell amid continued problems in the financial sector. And yes, we suffered with you as well.

Stocks = Risk

It’s hard to admit, but even experienced investment publishers go through drawdowns. Despite our best efforts to keep investors in the black, we sometimes dip negative. It’s very difficult NOT to experience the effects of a down market. Just as a ‘rising tide lifts all ships’, so also a falling tide (or market) lowers all ships. To spin this into another metaphor, if you have skin in the game, you will get burned…it’s just a matter of time.

If you invest in stocks, you will suffer risk, volatility, and yes, even loss of capital. You may not realize these losses until you actually sell, but the effects are still psychologically damaging. Stocks don’t move in a straight line. There are times of exploding growth, sideways meandering, and yes, even gut-wrenching declines. Such is life on the exchanges.

Unfortunately, many investors don’t take this into account when stock investing. Blinded by historical returns of the S&P or implied 20% returns that some managers discuss, investors jump into various funds, hire managers, or follow strategies, without appropriately weighing the risk. Every decision involving stocks should properly consider loss of capital.

Warren Buffett vs. Bill Gross

The chart above demonstrates the stocks’ relationship to typical return and risk, or loss of capital. As you can see, ‘Shares’ or Stocks have a higher potential for return, but also a higher implied risk. In other words, the more you own, the more you can lose OR gain. To drive home the point, let’s contrast a couple of investors…

1. Warren Buffet is the perennial stock investor. At last count, Buffett had a net worth around $62 billion. Still, Buffett has lost big during his climb to the top. In 1993, he bought Dexter Shoes for $433 million. When the value vanished, Buffett’s Berkshire was left holding the bag. Buffett’s stock investing carried with it significant risk, yet he’s still a billionaire many times over.

2. Bill Gross, aka The Bond King, is probably the best bond investor in the world. As you can see from the chart, bonds have lower risk and lower returns compared to stocks. As good as Bill Gross is at trading bonds, he’s hardly in the same league as Warren Buffett — Gross has an estimated net worth of $1.3 billion. Not to minimize Bill Gross, but his returns are somewhat limited because of his choice of careers: bond investing.

Stocks: Who Needs ‘Em?

If you like the 10%+ returns possible in stock-investing, then stock investing may be a great thing for you. But understand something whenever you buy stocks, ETFs or mutual funds. You can’t have those attractive returns without temporary losses. Extremely risk-averse investors should probably steer clear of equities in general.

But if you’re looking for index-or-better returns, then stocks are your best bet for delivering the goods. Keep your eye on the long-term prize when buying equity-based investments. Rewards tend to be higher with stocks than with any other investment. Over the long haul, you could be looking more like Buffett than Gross.

On the other hand, I wouldn’t mind a piece of Gross’s bond portfolio.