Almost every decision we make in life hinges on risk and return. We buy insurance to transfer risk. We drive to work at speeds that aren't too risky, but can still get us there on time. Similarly, whether you're a billion-dollar hedge fund manager or an individual investor, your job is to price risk. Intelligent investors understand the chances they're taking; here's a short list of those perils.
Investment risk
The value the stock market places on businesses can vary wildly from year to year, and even minute to minute. In the long run, the market values companies with reasonably reliable accuracy. But in the short run, Wall Street can be farther off the mark than American Idol flop William Hung in a singing contest.
Investors with strong stomachs can take advantage of wild swings, but only if they have the conviction. Be honest with yourself -- if you lack the mental fortitude to ride out that turbulence, you probably shouldn't take on a whole lot of investment risk.
Instead, you might want to concentrate on large-cap, high-quality stocks trading at reasonable valuations. For example, analysts at every major investment bank cover Inside Value recommendation Coca-Cola (NYSE:KO). Its major shareholders include long-term investors like Berkshire Hathaway (NYSE:BRK-A) and SunTrust (NYSE:STI). With its $127 billion market cap, only substantial buying and selling would make Coke's share price fluctuate wildly. In short, shares of Coca-Cola present far less investment risk than those of many other companies.
Business risk
I define business risk as the chance that the company's business model might falter. A couple of years ago, I noted that Eastman Kodak's (NYSE:EK) stock price seemed pretty cheap, but I just couldn't understand whether its business model would be able to make the leap from analog to digital photography. From my cursory glance, it seemed that the rules changed once you could store pictures on your computer, instead of paying a lot of money to get them developed.
While its own future remains uncertain, Kodak teaches us that investors need to define the business risks they're taking, and make sure they feel comfortable that they're getting paid appropriately for those risks. In fact, I think value investors should avoid as much business risk as possible. It's just too hard to have an edge when predicting the future of new technologies or untested business models.
I'd also avoid companies that lack strong competitive advantages, just in case more powerful competitors come along and push them out of business. It's not hard to predict that Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) will survive for decades, thanks to their low-cost distribution advantages; I'm less certain about mid-tier retailers, whose business models probably couldn't survive a prolonged pricing war from Wal-Mart or Target.
Balance sheet risk
Companies with a ton of cash have far more flexibility than those with considerable debt. Debt-laden companies depend on the credit markets for financing -- a risky proposition, especially recently. For the most part, the amount of risk you should be willing to take here should vary inversely with the amount of business risk.
If you're interested in a cash-burning fledgling biotech company, then you'd probably want to make sure it has tons of cash and no debt. That would help to buy the company more time to get its drugs out to market.
On the other hand, if you're investing in a company loaded with tons of debt, you'd better make sure that it has a great business and can throw off stable cash flows to pay down debt. That's how private equity firms generally make their billions.
Fools, when weighing your investment decisions, always know the risks you're taking. Stay away from situations outside your comfort zone. And make certain to counterbalance a company's debt level with the strength of its business, and vice versa. Investing's never entirely risk-free, but going in with your eyes wide open can help ensure your greatest chance of turning a profit.
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