Fool.com: On Bulls, Bears, and Statements of Risk (Fool on the Hill) January 14, 2000

FOOL ON THE HILL
An Investment Opinion

On Bulls, Bears, and Statements of Risk

By Bill Mann (TMF Otter)
January 14, 2000

One of the basic tenets of The Motley Fool is that we teach people how to think for themselves in regard to their investment decisions. This means many things, but one of those is this: when it comes to your investment decisions, trust no one. Not even us. You are the person best qualified to make decisions for you. But by taking the step of using our brains to make our own decisions, we also set ourselves up to make mistakes. And that's OK. In fact, speaking personally, I find that the mistakes I have made in investing and in life have been among the most valuable lessons imaginable. Painful, but valuable. Expensive, but I am richer for them.

The reason that any of us make mistakes is that humans lack the ability to see into the future. If we have somehow communicated to you that we believe that following any strategy espoused by The Motley Fool will somehow make you an invincible investor, then we have miscommunicated. There is no such thing as an investment strategy that is without risk, ours included. Even the most risk-averse strategies -- the burying of 100% of our assets in the backyard, the government bonds, the Certificates of Deposit, are not no-risk. In fact, I'd argue that such low-risk strategies are completely inferior because the returns they generate have badly trailed those of buying equity in the best companies and holding for the long-term.

If tomorrow the economy were to enter a recession that caused the stock market to decrease in value by 10% per year over the next 10 years, those who held government bonds throughout would look pretty smart by comparison. In that event, an investor in common stocks would lose 65.2% of their invested principal, compared to the government bondholder's return of 62.8%. The investor who emphasized safety would come out having looked like a genius, while those who took on more risk would have an ample, painful opportunity to see how much risk they could actually stand.

The current equity market is night and day from the situation described above. It is not unusual to scan the stock message boards and find that many investors, particularly newer ones, who believe that an annual return of 40% or 50% is unacceptable because it should be higher. And you know what? In a market where so few of the risk factors seem to jump up and bite people, they may very well be right. But like all things, this environment will change. Maybe not soon, but eventually. And those people who were being rewarded for having taken the biggest risks will suddenly feel the consequences when one or more of those potential risks become actual problems.

Risk is a part of investing; in fact, we believe that it is your friend. But it should not be ignored. The ebullient nature of this market has given investors a great deal of confidence that they can jump into high-risk, high-return stocks. And I'm here to tell you that this is correct, to a point. Investors should take on as much risk as they think they can handle. If you believe that you can weather a 60% price drop in the value of an equity, well then there is no need for you to sit on the porch and hold slow movers like Duke Energy (NYSE: DUK). But if there is one little nugget of wisdom we try to impart here it is this:

Understand the risks you are taking.

Every stock has an upside as well as a downside. Every single one. There is no such thing as a company without risks. And without exception, the higher the premium you pay for a stock's current earnings, the higher the risk. But risk is just that, a potential material event. It is something that may or may not effect your investment. Still, it is crucial that you know what the risks are, and how likely they are.

Over the past two weeks several Motley Fool writers (myself included) have touched the proverbial third rail by taking a critical look at some of the highest returning stocks. Some responses have been a variation of the "your just short the stock" with the strangely consistent misuse of the contraction for "you are." Most negative responses have been built around the contention that we just don't understand the company and its potential. These types of responses are largely misguided.

Over the past two months, I have taken a look at two of the hottest stock performers from last year: Internet Capital Group (Nasdaq: ICGE) and Qualcomm (Nasdaq: QCOM). In both instances I pointed out several real risks to the future earnings potential of the companies, ones that led me to call into question their current valuations. Internet Capital Group's price concurrently leapt through the roof, causing much crowing from some who disagreed with me, while Qualcomm has dropped, amidst some hair-rending by those who believe somehow that The Motley Fool "hates" Qualcomm. Both camps miss the basic point that was being communicated, and confuse a statement of risk with a prediction of price movement. We find a similar outpouring surrounding the hot discussion surrounding the analysis that Matt Richey, Tom Gardner, and I penned in regard to the clues that investors were given indicating Lucent (NYSE: LU) was due for a pummeling.

Risk analyses, when done in an intellectually honest fashion, are vastly different beasts than predictions of imminent demise. The Motley Fool produces articles with both forms of analysis, but we lean toward the former rather than the latter. And we NEVER give timetables. And it's not because we're cowards, but rather because we are not fortune tellers and have no more insight into future events than anyone else. Just because there is a potential risk does not mean it is GOING to happen nor does the fact that a potential risk did not happen, or has yet to happen, does not make it any less of a risk.

Often times those who disagree with us on a company point to the Rule Breaker's former investments in Iomega (NYSE: IOM) and 3dfx (Nasdaq: TDFX) as examples of our inability to pick stocks. Exactly! The managers of the Rule Breaker portfolio saw significant opportunity in these companies, and also significant risk. In both cases, the risks jumped up and bit us in the derriere. We lost money on 3dfx and lost much of our gains in Iomega. But we knew this risk existed for both, just as it existed (and STILL exists) for AOL (NYSE: AOL), Intel (Nasdaq: INTC), Celera (NYSE: CRA), and Yahoo! (Nasdaq: YHOO). Just because these investments have been successful does not mean that significant challenges to their eventual success did not and do not exist.

It is not a "bearish" statement to look at a position and identify the risks. It is prudent. High-reward stocks have high-risks, and, even though recent events may make it seem differently, there is no such thing as free money in the market. ICGE is at a tremendous valuation relative to its current value because of its enormous potential; the same with Qualcomm. But to dismiss the risks that these companies face is to invite disaster, even if she chooses not to visit.

The investor who is setting himself up for completely inferior returns is the one who either fails to see these risks or dismisses them out of hand. This is not a "bearish statement" anymore than a guarantee that the holders of Duke Energy will have consistent gains is a "bullish" one. We, as investors, may not sit at the table of huge gains unless huge risks get to play with us. This is the point of the articles about Lucent, ICG, Cisco (Nasdaq: CSCO), eLOT (Nasdaq: ELOT), or whatever company we cover.

Some here at the Fool tend to be hardest on the companies we like the most, particularly when a management or market action creates additional risks to us as investors. Still, these stories, as harsh as they may be, do not denote hatred, or even a hard prediction that such-and-such a company is going to go down in flames. And they especially do not say, "one month from now this company's price will be lower."

If I can impart one piece of Foolishness from this article it is this: pay attention to both the upside and downside potential for any company you are analyzing. For while the downside may not ever manifest itself, your best protection against it is to recognize that it exists.

Fool on!

Bill Mann, TMFOtter on the boards