Marty, My categorization of risk is one of the backbones of my investing style. I only believe in absolute risk adjusted for inflation. Risk relative to the market means nada to me. So, if you buy a stock, any stock, the absolute risk is that it goes to zero. True, G.E. is less likely to go to zero than Inmygarage.Com. But that is your absolute risk. If you buy a stock and sell a call against it, your risk is zero plus the call premium. A bit better. If you buy an option, zero is always your maximum risk and your most likely result. However, in the case of long stocks and options, I consider that a plus. If I buy a put or call for 1 1/2, I have 1 1/2 of risk. But, if I'm right on the issue, I can make 5, 7, 10 or even 20 points on that risk level. I should be wrong as often as I am right, but when I am right, I make much more than I lose when I am wrong. Thus, I use 90/10 to make certain I stay in the game until the winning numbers hit.
Does diversification reduce risk? Yes, but it does not eliminate it. You could buy 100 stocks on the German Stock Exchange prior to WWII and have huge diversification across industries. But you would have lost all your money. We tend to think that could never happen in the USA, and it is very unlikely. But diversification only limits risk within the bell curve.
Leverage greatly increases your chance of hitting zero. For example, LTCG supposedly only lost something like 4-8% on its investments, which is not fun, but something most investors could stand in a year. But since they were so heavily leveraged, that was enough to take their assets below zero.
Beta, again, is a measurement based upon history and probabilities. Ditto for R-squared. The problem with probabilities is that results occasionally go off the bell curve. And history usually repeats itself, eventually, but that doesn't help if you are broke before eventually happens. An analogy would be horse racing. Secretariat won many more races than he lost. But betting Big Red to win, the probability of loss is not zero, it is just small. If you bet too much money and ole Secretariat was off his feed that day, or somebody else was hyped up beyond his ability, you are no longer in the game.
So, I stick with absolute risk. I consider my cap app portfolio to be at absolute risk of going to zero, which is one reason it is so small in a bull market mania. I consider the 10% of my 90/10 to be at absolute risk of going to zero, which is why I like to get the names and the timing as right as I can. And I use a lot of insurance, long puts, spreads, etc. in my maximum income portfolios to make certain they have no or very low absolute risk.
Does this hurt my performance? No, but it might hurt somebody else's. I feel a degree of freedom that allows me to make more dramatic bets because I have my total portfolio well insured against hitting zero. Yes, there is a cost, but the ability to make what sometimes look like, and sometimes actually turn out to be, dumb moves makes my portfolio hum. This isn't bragging; it is just a statement of fact. I don't know anyone who does as well with maximum income portfolios as I do. And I don't think it would if I were worried about financial ruin. Other folks might find the belt and suspenders concept too restraining, especially in a manic trending market. My only comment would be that trends do not continue forever and neither do our nest eggs unless we are careful. |
