Calculated Risk

posted in: Everything Else | 0

 

I read this morning about an investor who lost 150k trading on margin (borrowed money from the brokerage). He thought he was managing his risk by only risking the 35k in his account on a $2 pharmaceutical stock, but turns out it was much more. After he checked in for the day down $106,000, he decided to start a GoFundMe page so people could pay off his debt to ETrade. My favorite part was that on his “give me a handout” page he specified for everyone that he “wasn’t one who usually asks for handouts”. Some people would call this person an idiot. And I would be first in line to do so myself. And believe me, 180 people on his GoFundMe page thought so as well…it was a pretty brutal narrative in his comments section. Trading stocks without understanding exactly what you are risking is not good at all. Trading on margins always seemed dumb to me…why would I want to borrow money to invest it and potentially end up owing someone money for bad investments? It just doesn't add up. But people are always looking for a shortcut. They want to invest money while skipping the whole savings/cutting back on expenses part. And it tends to end poorly. This differs greatly from our kickass plan to create a simple, happy life where we don't spend money on things we don't need, and then turn that money into more money slowly but surely. We are not betting our entire savings on a situation that is equivalent to spinning a roulette wheel. In fact, I would argue this guy should have done that instead. Would have definitely been more fun than being insulted by strangers on the internet. Anyway, with dividend investing we are SLOWLY building wealth, and by spreading our money across multiple steady companies, we manage our risk along the way.

But what if we WANT to add a little risk? You'll hear a lot of financial advisers say that when you are young, with many years until retirement, you should be investing with a calculated amount of risk. "Aggressive" is the word they'll use. The reason for this is that if everything goes to shit in the economy and you lose 30% of your investment money in a year (which of course is TEMPORARY value being lost! DON'T SELL!), you will have time to wait for the subsequent very good return years and end up in the green over the long haul. However, if you are 2 years from retirement and lose that same 30% in one year, you are looking at having to push back your retirement until the market returns to normal. It's in this point that we understand that the stock market is a unique type of risk. The real risk is in the short term, where things are out of our control. In the long term, things always even out, you give the good years a chance to cancel out the inevitable awful years and end up with some easy dollars in your pocket. And this is another reason that we never invest money that we'll need in the short term.

Adding risk to your portfolio is not for everyone. Maybe you won't be able to sleep at night if you invest in risky stocks as opposed to our dividend stalwarts. That's fine….don't mess with anything you deem risky enough to cause you stress. Personally, since I'm a few years from 30 and another 34 years from traditional retirement age, I have some time to inherit a little risk. Since I have recently passed the $50,000 portfolio value line, I figured it might be time to add some risk into my portfolio in seeking a bigger reward. This isn't for everyone, and you can decide for yourself if it’s right for you. The point of having savings and investments is so that you can sleep easy at night. If risky stocks are too stressful for you, I'd steer clear.

The key element in all of this is deciding what percentage of your portfolio will contain what you deem higher risk stocks. HINT: KEEP IT LOW. I have chosen to allocate 2-3% of my portfolio for this category. This means that 97% of my portfolio at all times will be in what I consider safe, more stable stocks. They'll pay me on a monthly basis, usually increase dividends every year, provide some fairly safe price growth, and slowly pave my way to financial independence.

But let’s go ahead and go over what to look for in a risky stock. People can look for all different kinds of things. It could be a non-dividend paying stock. It could be a small company that you are very familiar with that might not have the steady history of a Walmart or Procter&Gamble. It could be the company you work for. For me, I like to stick with dividend stocks. I recently picked out 2 stocks to try. My main criteria falls in line with Warren Buffet's famous quote "The best thing that happens to us is when a great company gets into temporary trouble...We want to buy them when they're on the operating table".

Here is what I look for:

  • Look for a stock that has recently lost a lot of its value. In other words, something that is "on sale" with theoretical room to return to its past value. These are companies that MIGHT continue to drop, but also could double up in price by returning to their previous range. I’d prefer the return to greatness but understand the inherent risk that it might not happen.
  • Positive earnings (EPS) - as long as the company is still earning money, we can assume it’s within the realm of possibility for them to return to high values.
  • History of Dividend Payments - doesn't necessarily need to be the increasing dividends for 10+ years that we look for in the rest of our portfolio. I look for a steady history of at least 5 years of paying some sort of dividend.
  • P/E ratio is reasonably low, I still look for anything under around 30.

 

Picking these companies is fun, as long as you see them as what they are. Have no expectations and keep it as a small % of your portfolio. We obviously won't be expecting to lose all of the value because we aren’t picking anything randomly like the idiot who lost it all. We are still going to pick fairly steady companies that have fallen on what we hope to be temporary hard times. Most of the "wins" that come from this section will be growth in the overall price, if they regain their previous value. I prefer dividend payers for all the usual reasons:

1. They slowly pay back my principal, thus lowering my risk by the month
2. If the dividend is high to abnormally high (when stocks lose a lot of value, the dividend yield goes up by default) all we will need is for the stock to maintain its price and keep paying us dividends in order to be successful.
3. They increase my monthly cash flow to buy other things.

 

For these reasons I have chosen 2 stocks to start my "risk section". I feel like I’m repeating a lot because I’m imagining someone commenting “well…you said to buy X stock and I lost my entire portfolio when it dropped”. I wouldn't advise buying these unless you are truly aware of the risk. These stocks temporarily make up about 1.3% of my investment account and I'm comfortable with that amount at the moment. If I lost all 1.3% of that money I would still have the other 98.7% of the portfolio left. Do yourself a favor and keep this section low. You'll feel better if your picks don't work out.

There are tons of dividend stocks that could fit this mold but I have chosen the following:

 

M (Macy's) 

We all know Macy's. The stock tumbled from a high of 73 in July of this year (2015) with a very bad earnings quarter and now sits at around $39 per share. Let's look at their stats:

Market Cap: 12.77 Billion
P/E Ratio : 10.29
Dividend Yield: 3.67%
EPS: 3.81

All solid statistics. They have grown their dividend aggressively for 4 straight years and have paid a dividend in general every 3 months since 2003. While risky, I can't complain about any of these metrics and I can hold out hope that the price returns anywhere close to the previous high. Until then, I can collect my fairly strong dividend payment every 3 months. I have bought 8 shares @ $38.90 per share for a total investment of $311.84.

 

PSEC (Prospect Capital Corporation)

This is an investment company I stumbled upon while browsing through stocks. Essentially, they are like any other investment company, in that they lend money to privately held companies. The stock was as high as $11.20 in the beginning of 2014 and its 52 week high price is currently $9.71 and now sits at $7.50. Let's look at their stats:

Market Cap: 2.66 Billion
P/E: 9.32
Dividend Yield: 13.35%
EPS: 0.80

 

All pretty solid, EPS could be a bit better though. PSEC has paid a monthly dividend since 2010. They paid a quarterly dividend before that all the way back to 2005. The dividend payment here is very large at 8 cents per share every month. It has bounced around and hasn't always increased, but we're looking at a stock that has been on a price decline for a while now and still has a solid P/E ratio, a reasonably large market cap, and a high dividend yield. All I really need is for them to maintain this stock price (or it could even drop a little) to be successful at that high of a dividend payout. Given the current dividend yield, I will make $55 of my current investment back per year without ANY price growth. I own 55 shares at an average price of $7.33 for a total position of $412.

So those are my current two companies in my risk category, and I'm sure there are tons and tons of companies that you can choose. It’s fun to go off the beaten path a little bit as long as it’s a very small percentage of your portfolio. While I enjoy owning the stable companies and collecting the dividend every month, it’s nice to try to spot the next up and coming company for a potentially big reward. (Have I mentioned enough that it should be a small %!). For people who aren't interested in this part, carry on with your kickass safe dividend investing strategy. More power to you. I just find it a little bit enjoyable to track some riskier options and use the years of investing ahead of me to take on a bit of risk and hopefully double up on a few small investments.

Anybody have success with an individual stock that might have doubled or tripled up over the years? Would love to hear a success story 

Please follow and like the blog:
Facebook
Facebook
Follow by Email
RSS
Google+
http://monthlycents.com/2015/11/21/calculated-risk/

Leave a Reply

Be the First to Comment!

Notify of
avatar
400
wpDiscuz