One aspect of investing that many people struggle with on a daily basis is identifying and quantifying risk. Let's face it, nobody wants to admit she has a risky portfolio. With all the valuation metrics available at our fingertips, how could we take on too much risk? The answer is simple: We don't really know what risk is.
To the average investor, risk has a negative connotation. "Avoid risk" likely invades your subconscious. But should it? And can we really avoid risk? The answer is no. Risk exists on many levels, but the most common in the average investor's mind is the risk of losing money. It's a struggle for us all and one that should be considered. However, let me offer another risk: the risk of not growing your wealth enough. We all must learn to embrace risk and understand that it's unavoidable.
When we choose to devote a portion of our portfolio to individual stock picks, we risk losing money compared to merely placing the same funds in an index fund. So why do it? It can be fun, and perhaps our ego leads us to believe we can emulate the legendary investors of our time who regularly outperform the market. Maybe we just find indexing a little boring. Whatever the reason, there's always that elephant in room. We must not avoid it.
Risk can be embraced and harnessed for what it is: a way to grow wealth faster. It may feel good to have a stock portfolio full of AT&T, PepsiCo, Bristol Myers and the like, but if your portfolio is made up of nothing but plain Janes, over most time frames, you're going to be better off in an index fund.
A portfolio stocked with utilities and staples augmented by a municipal bond ladder might provide some investors with a large enough return to satisfy their needs, but shouldn't we strive for something more than merely getting by with satisfactory returns? Shouldn't we try to find one or two stocks that boost our gains so greatly we don't ever need to wonder if our utilities will raise their dividend? That would be nice, right?
Although every portfolio should have some stable stalwarts that should help cushion the blow during any market downturn, don't make the mistake of using the same valuation metrics you used to find them to identify the more speculative stocks in your portfolio. Be sure to ask yourself, "Am I taking enough risk?" vs. merely, "Is this stock too risky?"
The most fabled valuation metric is of course the price-to-earnings ratio (P/E), which is what an investor pays for a company's earnings. Some people like to use P/E based on earnings over the trailing 12 months, while some folks like to use P/E based on earnings estimates for the next year. The truth is most people use whichever one best defends their current view of a particular equity. This applies to all valuation metrics. Search your feelings; you know it's true.
To be honest, P/E isn't very helpful. We're looking for stocks that can double, triple or even turn into the elusive "10 bagger," as legendary investor Peter Lynch called it. There might be a few companies in history that traded with P/Es of 10 or 12 and then doubled or tripled in value quickly, but there probably aren't many.
On occasion, P/E can be helpful when comparing stocks within a sector. When McDonald's was trading around $90 in early 2015, its P/E was around 20. For McDonald's, a P/E of 20 is not cheap, but when you compared the stock to the rest of its sector, it kind of was. I'm not talking about comparing it to Shake Shack, either. Burger and fast-food chains that had been around for decades were trading at P/Es of 30 to 40. Seeing that McDonald's had a 3%-plus yield at $90 and would simply close the gap with its peers, you knew were going to get a decent return, right? In this way, P/E can be helpful.
But don't wrap yourself too tightly in the warm blanket that is P/E. Be wary, because P/E ratios can stay low for a long time. Stagnant earnings, falling revenue, and any number of other things can paint a deceptive picture of a stock free from much risk. IBM is one of the best recent examples.
Judging a stock merely by P/E will keep you out of the best gainers. I like companies that are growing revenue. It's hard to massage sales. You can be sure that if a company is growing revenue regularly at 20%-40% year over year, it will not be trading at an attractive P/E. By the time it does, decades could have passed. The obvious examples of this are Amazon and Netflix.
It can appear to be dangerous to pay "up" for companies like these, and one day it will be. They'll mature, start paying a dividend and graduate into a blue-chip value stock, but that could be decades away. Don't you want to be there for at least part of the growth stage? Can you risk missing out?
By the way, if you ever have a friend or casual market observer question an individual stock you own based on its valuation, simply reply, "It has asymmetrical risk to the upside." They'll leave you alone quickly. You'll also sound really smart.
With the greatest risks come the greatest rewards. The equity market is risky overall. It can trade down 20% at any given time for almost any reason. When it does, it's the riskier equities that will outperform during the recovery. There's always a recovery despite what you might read or hear. A portfolio free of what you might perceive to be risky assets will almost certainly underperform.
Risk is not evil. You must embrace it and accept that it cannot be avoided. Don't avoid a stock merely because it appears expensive. Dig deeper, because there could be something there. The sooner you realize it, the better your investment returns will be.