Chapter 2: Basic Investment Principles
Learning to compromise between risk and return is a necessary skill when it comes to investing.
Risk and return will rarely corelate
Framework
We can't tell you exactly how to invest since that decision is personal, but we can provide you with the framework to make informed choices by explaining what is risky and what is safe.
Risky/High returns
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Young companies are riskier than older ones because they often lack a proven track record and stable revenue streams. They may still be developing their products or services, which can lead to uncertainty and higher volatility. Additionally, young companies typically face more competition and operational challenges. On the other hand, older companies usually have established market positions and reliable income, making them more stable investments.
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New industries can be risky because they often involve untested technologies or business models, leading to uncertainty about their long-term viability. Regulatory environments for new industries can be unpredictable, potentially leading to sudden changes that impact profitability. Additionally, new industries may face high levels of competition as many companies vie to establish themselves. Lastly, consumer acceptance and demand for products in new industries can be uncertain, adding to the risk.
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High valuations pose a risk because they often indicate that a stock is priced well above its intrinsic value, making it more vulnerable to market corrections. If the company fails to meet growth expectations, the stock price can drop significantly. Additionally, high valuations can lead to reduced returns as the stock's price may already reflect much of the anticipated future growth. Investors may also become overly optimistic, ignoring potential risks and overestimating the company's potential.
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High debt poses a risk because it increases a company's financial obligations, which can strain its cash flow and reduce its ability to invest in growth opportunities. If the company's revenue declines, it may struggle to meet debt payments, leading to potential default or bankruptcy. High debt also makes a company more vulnerable to interest rate increases, which can raise the cost of borrowing. Additionally, heavily indebted companies may find it difficult to obtain further financing, limiting their financial flexibility.
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A fast-growing company carries the risk of high market expectations, meaning any small disturbance in its growth can cause a sharp drop in its stock price. Investors often price these stocks based on future growth potential, so even minor setbacks can lead to significant market reactions. Rapid growth can also strain the company’s resources and operational capacity, increasing the likelihood of mistakes. Additionally, fast-growing companies may face intense competition and regulatory challenges, which can further impact their growth and stock performance.
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Small market cap companies are risky because they often have less financial stability and fewer resources compared to larger companies. They can be more vulnerable to economic downturns and market volatility. Additionally, small market cap companies may have limited access to capital, making it difficult to fund growth or navigate financial challenges. Their stocks can also be less liquid, meaning they are harder to buy and sell without impacting the market price.
Safe/Low returns
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A mature company is considered safe because it typically has a stable financial foundation and extensive resources. These companies are more resilient to economic downturns and market volatility due to their established market positions. Additionally, mature companies often have reliable revenue streams and access to capital, enabling them to fund growth and manage financial challenges effectively. Their stocks are usually more liquid, making them easier to buy and sell without significantly impacting the market price.
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A mature industry is considered safe because it generally has well-established companies with proven business models. These industries have predictable revenue streams and are less susceptible to market fluctuations. Additionally, mature industries often benefit from stable demand and less intense competition compared to emerging sectors. Their established regulatory frameworks and market practices also reduce the risk of unexpected changes affecting business operations.
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Low or mid valuations are considered safer because they suggest that a stock is priced closer to its intrinsic value, reducing the risk of overvaluation. These stocks are less vulnerable to market corrections and have more room for price appreciation. Additionally, companies with lower valuations often provide better dividend yields, offering steady income to investors. They also tend to attract value investors who focus on long-term stability rather than short-term growth, further stabilizing their stock prices.
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Low debt is considered safe because it indicates that a company has fewer financial obligations and more flexibility in its operations. This reduces the risk of financial distress during economic downturns or revenue declines. Companies with low debt can invest more in growth opportunities and are less affected by interest rate fluctuations. Additionally, they have better creditworthiness, making it easier to obtain financing if needed, which further enhances their financial stability.
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Low growth is considered safe because it typically reflects stable and predictable business operations. Companies with low growth often have established markets and steady revenue streams, reducing the risk of significant fluctuations. This stability allows for consistent dividend payouts and reliable returns for investors. Additionally, low-growth companies usually face less competitive pressure and fewer operational risks, making them more resilient to economic downturns and market changes.
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High market cap is considered safe because it usually indicates a company with substantial financial resources and a strong market position. These companies often have diversified revenue streams and robust business models, reducing the risk of financial instability. Their size and influence in the market make them more resilient to economic downturns and competitive pressures. Additionally, high market cap companies are generally more liquid, making their stocks easier to buy and sell without significant price impact.
Factors that should be taken into consideration
Time Horizon
Emotions
Time horizon is an important factor that should significantly influence your choices when balancing risk and return. If you seek higher returns and are willing to accept higher risk, you need to extend your time horizon. This is because many high-risk companies require time to realize their potential and achieve growth, allowing you to weather short-term volatility and capitalize on long-term gains.
Your emotional sensitivity should also influence your investment choices. If you are highly emotional and prone to panic selling, you should definitely lower your risk. Panic selling high-growth stocks during rough times can be detrimental to your gains, so opting for safer, more stable investments can help you manage your emotions and protect your portfolio.
Goal Size
Goal size is a less important factor but should still be considered. If you need a large sum of money, you should be prepared to take on more risk to potentially achieve higher returns. Conversely, if your financial goals are more modest, you can afford to take on less risk and still meet your objectives.
Goal Flexability
An often understated factor in the risk and return relationship is the flexibility of your goal. Does it matter if your goal is reached a year early or late? Do you have a specific date by which you must reach your goal? These are important questions to consider. If you can be flexible with your goal timeline, you can afford to take on greater risk, potentially leading to higher returns.