Investing Is a Risky Proposition

Investing is an action fraught with risk, even though many choose to ignore this fact until after they have been hit by it. Perhaps some investors will never end up on the wrong side of the risks they take. That doesn't make them smarter investors, necessarily. The American financial system is structured to protect us from risks caused by malfeasance, but it does not do much to protect us from bad decisions.

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By Bill Mann (TMF Otter)
November 17, 2000

I was at the gas station this morning when I realized that someone had hit-and-run my car the other day. Now, once-pristine sheet metal is instead a gnarled canyon of flaking paint and warped steel.


My blood started to boil. I went into paroxysms of rage and misanthropy, unable to believe that someone could be so pathetic as to not leave a note. There was just no way that this person was oblivious to the fact that he or she had pummeled my car.

My faith in humanity was restored when the claims representative at my insurance company told me that, indeed, they get claims from people who hit parked cars and leave notes all the time. Though I do hope the person who did this feels guilty. In fact, if you've ever hit-and-run a parked car, why don't you just feel guilty for a second.

OK, that's enough. Thanks for caring.

I had a deeper realization, though. It actually made me both sad and embarrassed at the same time. It is this: My life is so worry-free that I have the luxury to treat someone hitting my car as some unspeakable travesty of justice. People all over the world are being killed, tortured, or persecuted for the color of their skin, their political beliefs, or their religion. There are countries where government not only does not function to protect its people, but actively represses them. Someone hit my car. I'm out a few hundred bucks to get it fixed, but it is no big deal. I am not being persecuted.

We need to remind ourselves of this fact as we consider why we invest. The United States has the best financial disclosure system in the world, the most liquid market, and the lion's share of the world's great companies. Our ability to participate in the growth of the companies in this market is a privilege.

Regardless of the protections afforded those who invest in America's public companies, most of these companies will fail. Not necessarily go belly up, but they will in some way let their shareholders down at some point. For many companies this letdown will be both dramatic and traumatic. For the shareholders, even more so.

Investing is all about risk
When you invest, you are therefore committing an act of faith. It is an act of educated faith, grant you. But, with every investment there is a real, non-zero possibility that the money you set down will never come back. Therefore, your money, your invested capital, is at risk. The level of risk depends on such things as the multiples you are paying, implied growth rates, volatility, and other measurable factors.

The thing that made me so mad about someone hitting my car was that I was engaging in a very low-risk activity at the time: the car was parked in a public lot. That I was not driving down the interstate blindfolded when the damage happened means nothing. I took a risk, albeit a minute one, and I rolled snake eyes.

But, does that mean I should no longer park my car? That I should avoid the risk of getting hit by walking everywhere? No, that would be stupid, because neither the chance nor the consequence of the risk necessitates the inconvenience of avoiding it. The same cannot be said for people who, for example, choose to walk through an explosives plant with a lit match. Sure, they might come out fine, but they still have done something with huge risks and awful consequences. Best to be avoided.

People are so accustomed to ignoring risk until they end up on the wrong side of it. In life, this can be fatal. In investing, it can cost us boatloads of money. Still, we tend to focus on the risk after it bites us, and that is wrong. I'll give you an example. I own CMGI (Nasdaq: CMGI), which has dropped more than 90% from its highs of this year. Fortunately, I've owned it long enough that I am not deeply upside down on the stock, but like many people who held CMGI, I have been very surprised at how fast the wheels seemed to have come off of this company once the IPO market cooled off.

However, my (and everyone's) risk in CMGI did not happen when the company shares dropped. It happened the moment I bought the stock. Worrying about the risk now that it's at $13 a stub is like joining the Army to avoid the draft. I knew that the company was selling at huge multiples to its cash flow, and that the company was heavily reliant on non-recurring events for its earnings. But, I was convinced that CMGI had a competitive advantage that, from a business fundamentals standpoint, would withstand the imminent time in which the Internet was not seen as such a bubble.

I was even prepared for the company to fall from its highs -- which I believed to be ridiculous, but not 90% ridiculous. And yet, here I am, along with thousands of former "CMGillionaires," licking my wounds from a stock that has done me wrong.

My loss is not the fault of the company or its management. The mistake is my own. I took a big risk and came up on the wrong side of it. It was not the first time, it will not be the last. When we invest in speculative companies, we must be especially vigilant of the risks facing the company. This has nothing to do with defending the company against the opinion of others -- that is nothing more than a tempest in a teapot. It does have everything to do with constantly looking at threats to a company's business, analyzing them, and adjusting your opinion of the company accordingly.

For every fallen angel company, I see a bevy of class-action lawsuits. From the outside, it would appear that some managements deserve having legal action taken against them. Most do not. But those who reflexively feel the need to find someone else to blame for their investment foibles, whether they join these suits or not, have completely missed the point.

You bought the stock. You took the risk. It was your right to do so, but if the stock fails to perform, it is your responsibility to suffer the consequences.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards