Refresh the Basics Part 3

March 1, 2014

Investment Newsletter for the end of February, 2014

I am continuing with my theme from last months of refreshing the basics.  It never hurts to reinforce the core concepts.  I always aspire to promote and expand other people’s financial knowledge.

First, I need to gloat a bit.  Last month I criticized Bitcoin as lacking any reason to exist.  This month, the largest seller went bankrupt, with hundreds of millions US dollar equivalent missing.

The market was great in February.  Almost all the January decline went away.  In December, when the market was soaring, I received several phone calls from clients wanting to go more aggressive.  I convinced them to hold to the plan.  In January, when the market stunk, I received panicked phone calls.  These clients wanted to know if they should cash out.  I convinced them also to hold to the plan.  The profit is made by not reacting to the greed and fear cycle.  The crowd is often wrong in these short term swings.  Only half way joking, when someone (not a client) flagged me down at the doctor’s office and asked if they should sell out and asked why the government isn’t doing something about this month’s economic collapse, I knew it was time to buy.

But is there anything you can do about risk?  Partially.  Investment risk is broken into two components.  Individual company risk and total market risk.  An example of the first would be Microsoft being sued by the federal government (bad risk) and later winning the lawsuit (good risk).  Microsoft stock price changed but the market as a whole did not.  An example of the second would be the stock market crash of 2008.  Everything went down.

The individual company risk can be diversified away.  If I have 50 companies in my portfolio, Microsoft being sued does not change my total very much.  Also, the weird good risks and weird bad risks balance against each other.  This risk is diversified out of existence with mutual funds.  A mutual fund is simply a collection of many stocks.

The market risk cannot be diversified away.  If the whole market is tanking because the towers were hit, combining stocks into a portfolio does not change the decline.

You are rewarded with potentially higher profits for taking risk.  Which risk?  Since you can get rid of the company risk, there is no reward for it.  Market risk is rewarded.  If you have a more aggressive portfolio, you will have higher returns over time.  You will also be on a more exciting roller coaster.

I believe that there is no legally available knowledge which will tell you in advance if a stock will go up or down.  All knowledge is publically available and immediately reflected in the stock price.  The only factors left that can change the stock price are the two risks above, company risk which can not be predicted, and overall market risk.  This point, in a nutshell, is why I do not buy individual stocks.  I can get rid of the company risk in a mutual fund.  Since all knowledge is already in the stock price, the mutual fund will have the same return as the stocks in it.  The same profit for less risk.

Thank-you for your trust.  Let me know if you have a topic that you are interested in.

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