No matter what you do, your money is at risk. Even if your cash is stashed in an insured certificate of deposit, it's not entirely free from worry. Sure, by the traditional sense of "risk," the CD is pretty well secured. When the deposit matures, you'll almost certainly get your cash back, along with some interest for your troubles. Yet just because you're guaranteed to get your money back doesn't mean you'll be as well off as you were before. In that intervening time, a few things happened to claw away at the value of that investment.
- The interest you earned was taxed, at your marginal tax rate.
- Inflation took a chunk out of what your money could buy.
- You couldn't otherwise use the cash while it was locked up.
In other words, you lost ground because of friction, loss of purchasing power, and opportunity costs. Sure, they're not quite as obvious as the volatility associated with stocks. But even so, they are still very real, and they only get worse as time goes by. According to this handy calculator, it takes $1,000 in 2006 to buy what $284.78 could buy in 1976 -- just 30 years ago. A "safe" investment that has gone nowhere has really lost you almost three-fourths the worth of your money.
Balancing all your risks
Of course, just because your money is at risk no matter what you do doesn't mean you need to be reckless with it. There's no need to walk up to a roulette wheel at a casino, put all your money on seven, and hope the ball stops on your number. You could win big, but you're more likely to lose it all, quite quickly.
Instead, you need to search for a sweet spot on the risk spectrum. Find the right investing strategy where you are adequately compensated for the risk you are taking, without putting yourself in substantial jeopardy of losing it all. It means redefining risk to include not only fluctuation in the number of dollars you have, but also how much purchasing power you keep when all is said and done. From that perspective, investments that seem safer in the short term often turn out to be riskier as your time horizon lengthens. If you invest appropriately and keep a perspective of the complete risks you're facing, you're actually at less long term risk in stocks than in cash.
The fine print
That previous sentence starts with "if you invest appropriately." Ask anyone who bought shares of fiber optic company JDSU (NASDAQ:JDSU) in early 2000, based on the "picks and shovels of the Internet" argument, what happens if you don't. The reality is that if you want to lower your long-run risk by investing in stocks, you have to pay attention to the true worth of what you buy. If you pay too much for a company, you immediately start out in a hole.
That true worth is where we focus at Motley Fool Inside Value. The whole concept behind the strategy we follow is a method of risk-reduction based on a firm's true worth. Benjamin Graham, the father of value investing and the man who taught Warren Buffett how to invest, called it "the margin of safety." It's how you can take advantage of Wall Street's wild mood swings to profitably invest while simultaneously reducing your risk of total loss.
How it works is simple. You calculate your best estimate of what a company is really worth. Then, knock off a decent fraction (say 20%) from that amount. Only after subtracting that discount do you look at the stock ticker and discover what the market thinks. If Wall Street believes the stock is worth less than your discounted price, figure out why. It may very well be fixable. Take, for instance, the derivative accounting mess that tripped up mortgage giant Freddie Mac (NYSE:FRE) or the disastrous "Made for You" campaign by McDonald's (NYSE:MCD) that slowed down service unacceptably. In each case, there were problems that justifiably knocked down the stock, but those issues were fairly straightforward to repair. In such an instance, feel free to buy.
On the other hand, if it's a long-term problem that seriously jeopardizes the business's ability to survive, stay away. For instance, KrispyKreme's (NYSE:KKD) overly aggressive expansion plan not only consumed significant capital but also led to a capacity glut that made it difficult for the franchisees in its most crowded markets to sell enough to operate profitably. The company may still survive, but with too much capacity producing a fad product for a fickle consumer, the repairs to the business will be neither quick nor easy.
The rebound
If you buy companies at discounted prices and wait patiently, eventually they start returning to their fair values. As an investor who buys when companies go on sale, you earn excess profits from that return to fair value. With enough of those discounted purchases and time under your belt, you can earn enough from your investing to sufficiently reward you for the financial risks you're taking.
Taking an excerpt out of a recent Inside Value issue, here's how it works in practice:
|
Total Return |
S&P 500 Return |
Return vs. S&P 500 | |
|---|---|---|---|
|
All recommendations |
13.0% |
8.0% |
5.1% |
|
Recommendations more than 6 months old |
16.3% |
10.1% |
6.2% |
|
Recommendations more than 9 months old |
19.0% |
10.9% |
8.1% |
|
Recommendations more than 12 months old |
23.2% |
12.6% |
10.6% |
As our experience suggests, the longer time you have to put your money to work in value focused investments, the better off you are. That's true regardless of whether you're looking at absolute returns, returns versus total risk, or returns versus a market benchmark like the S&P 500.
The power of patience
You can beat the market with value-focused investing, but it takes time. The fact is, for most companies, we mere mortals have virtually no impact. In order for a bargain priced company to rise from the ashes, it usually takes a serious force quite a bit larger than the will of an individual investor.
For instance, it might take another company's board of directors. While they have the financial muscle to make an impact, they operate within constraints that slow them down. For example, former Inside Value selection MCI was dirt cheap when selected for the newsletter. Yet it took a buyout offer from Verizon (NYSE:VZ) before the company finally escaped the cellar. While the purchase may have been tossed around Verizon for months while MCI languished, the board could only move so fast, since it needed to ensure it was protecting the interests of its existing shareholders. Some catalyst was inevitable; the only question was when it would happen.
The Foolish bottom line
No matter how you manage your money, you are exposing it to some type of risk. By looking at the complete risk picture and focusing your long-term money on value-priced stocks, you can more easily earn a sufficient return to compensate for those risks. All it takes is a combination of time and a dedicated focus on uncovering a company's true worth.
Do you like getting more for your money? Subscribe to Inside Value today and we'll also send you Around the World in 80 Minutes, the Fool's guide to international investing, absolutely free. Still not sure? Click here to start your free 30-day trial. In that trial, all you'll be putting at risk is your time.
At the time of publication, Fool contributor Chuck Saletta owned no shares in any of the companies mentioned in this article. The Motley Fool has a disclosure policy.
