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.