Investing Risk Is Okay. These Stupid Investing Risks Are Not

Life is all about risk.

From the second you rise in the morning to the moment you crawl safely back into bed at night, you are taking risks of some sort.

All day we make decisions about what risks we are willing to accept and which we are not.

Do we cross at the light in the crosswalk, or do we dash across a busy avenue avoiding traffic? Should we tell our boss what we really think, or just nod and move along?

What risks will we take and which will we avoid? Life is just a never-ending string of choices about risk and reward.

The big choices all have risk and reward trade-offs, don’t they?

If we follow the designated path of getting a job and working in a “normal” career, we should avoid the risk of ruin. But if we follow our dreams and become a writer, a singer, a ballplayer, the rewards could be tremendous.

However, dream chasing potentially has a very high cost and takes an enormous amount of dedication and hard work with the odds against you.

As Damon Runyan once noted “Furthermore, in Dream Street are always many hand-bookies and horseplayers, who sit on the church steps on the cool side of Dream Street in the summer and dream about big killings on the races, and there are also nearly always many fight managers, and sometimes fighters, hanging out in front of the restaurants, picking their teeth and dreaming about winning championships of the world, although up to this time no champion of the world has yet come out of Dream Street.”

If you dash across I-Drive against the lights here in Orlando, the local traffic stats tell me you have a pretty good chance of getting run over by a tourist looking at their traffic app for directions or arguing with their spouse about where to go to dinner.

Crossing at a crosswalk reduces those odds of a high splat factor. Meeting a woman at a church and finding out you have common interests and aspirations, then dating for a year and getting married, has much higher odds of success than choosing your spouse at the bar behind the crap tables at Caesars in Vegas at  3 am and getting married at the Elvis Love Chapel as the sun comes up.

Yet without risk, nothing great is ever achieved.

If Bill Gates doesn’t decide to bet on himself and drop out of Harvard, there is no Microsoft (MSFT). If Warren Buffett goes back to Omaha and becomes a stockbroker, there is no Berkshire Hathaway (BRK). If the pilgrims and pioneers do not take incredible risks to find a better world, there is no United States. Great dreams can require great risks.

But there are smart risks in life, like betting on yourself when you know you have an edge. Having a child in an uncertain world is also a risk, but trust me when I tell you that it can pay off handsomely. And then there are dumb risks in life as well, like the sunrise wedding in Vegas with the wedding rings fashioned for a tequila label.

So all of life involves decisions about risk versus reward.

And investing is yet another great example of that.

Here are the dumbest investment risks, and the smartest…

Call These Risky Stocks What You May – I Call Them Zombies

When we get to the stock market, everything is about risk versus reward, isn’t it?

The problem is that no one ever thinks about the risks.

Potential rewards, hot tips, and sexy stories are the flavor of the day and what keeps the Wall Street Machine fed its daily bread.

No one thinks about the possibility, or probability, that a big trade will finally send us too far over the top.

I run a screen every week to uncover stocks I consider Zombie stocks. These companies have high debt loads and trouble generating enough cash to pay their interest, not to mention grow the company.

I ran some rough and dirty tests on these stocks. Turns out, when you buy one of these stocks, you have a 25% chance of losing more than 50% over the next year and an almost 60% chance of taking some sort of a loss over the past five years. So it’s tough to make money when the probabilities are against you. But that’s okay because we would never own those stocks, would we? Or would we?

Right now, Tesla (TSLA), Mattel (MAT), RingCentral (RNG), and FireEye (FEYE) all make the list. So do dozens of small clinical-stage biotech companies and US oil and gas exploration companies. In the past few years, Pandora (P), Spotify (SPOT), SunPower (SPWR), Apache (APA), Lending Club (LC), and many other popular well know companies have been on the list with less than satisfying results for their investors.

While they’re out of business, you’re in luck

Another screen that I use identifies stocks that analysts love, but that are using more cash than they brought in over the past year. Buyers of the stock share roughly a 20% chance of a 50% or greater loss over the next year and close to a 60% chance of losing at least some amount of money, according to my quick run through. Of course, we would never buy these stocks either.

Right now, Netflix (NFLX) is at the top of the list. Royal Caribbean Cruise Lines (NCL) is on there as well. So is ShotSpotter (SSTI), one of the hottest story stocks in all of Wall Street the past couple of years. And once again, so are many of the small biotech and energy stocks we all just love to speculate on in our search for the next big thing.

This is low probability risk-taking. The cards are stacked against you and making money becomes a matter of luck and intelligent investing.

Buy These Banks and REITS to Avoid the #@$-Kicking Contest

Now let’s look at high probability investing.

Buying well-capitalized small banks below tangible book value over the past five years has worked pretty well. At any given time, there was just a 23% chance one of your stocks would go down over the next year, but more importantly only a .40% chance of taking a loss of 50% or more.

Buying well-financed Real Estate Investment Trusts below asset value has also been a high probability strategy over the past five years. There has been a 31% chance of one of your REITs going lower the year after you buy it, but the chance of a loss greater than 50% is just 1.2%.

One of the keys to successful investing is avoiding big losses, and these two strategies would have helped you do so.

The quick and dirty studies I did would probably not hold up to peer review at the University of Chicago, but I don’t think feeding them into a supercomputer to parse the data would change the numbers very much.

Investing with the odds of success in your favor will get you a lot closer to realizing your hopes and dreams than a series of high-risk, low probability bets.

Successful investing is much more a story of probability than just possibility. Charlie Munger is one of the richest guys on the planet because he understood that simple fact. When approaching the task of investing – and living – keep Mr. Munger’s words in mind as he tells us the following:

“If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an #@$-kicking contest. You’re giving a huge advantage to everybody else.”

Enough said.

To the Max,

Tim Melvin

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