Wednesday, January 24, 2007

TIME FRAME VS. RISK - The Inverse Relationahip

All investments have risk. No matter how safe they look and feel, there are risks involved. Let me get that out of the way first. You can never eliminate the risk you assume when you plop down your money on an investment. The question then becomes, how do we minimize that risk? There are many alleged ways, do exhaustive research, only buy bonds or CD’s, avoid tech stocks, etc, etc, etc. Many of these “risk avoidance” options also come with the “return avoidance” result. Yes, you can almost totally eliminate all risk by buying a cd at your local bank but in today’s low interest rate environment you are barely making a return in excess of the inflation that is eating away at those dollars. Also, you have now locked those funds away and can only get YOUR money back should you need it by paying the bank a hefty penalty. There is risk.

This discussion will focus on stocks. While the reasoning I will illustrate does apply to most investments, the discussion will focus on the effect on common stocks and their investors. Let’s look a two charts and try to decide which looks like the better investment:

A quick look would have us saying chart #1 is the far superior investment. Here is the thing though, both charts are of Sears Holdings (SHLD). Chart #1 is SHLD since its inception and chart #2 is its chart for the past 3 months. Same investment and depending on your time frame, two very different results.

When you have a very short time frame, your attention to every minutia of information that may effect the stock is mandatory. Let’s use the 3 month chart above. This investor bought SHLD in October hoping to capitalize on the typical holiday bounce retailers seem to enjoy. What “risks” are there to his investment? Off the top of my head I can think of same store sales at Kmart fall, same store sales at Sears fall, warm weather keeps people out of the mall, snow keeps them from getting there, an “analyst” downgrades the stock out of the blue, the Fed decides to raise interest rates, Iran cuts off oil and it spikes to $80 a barrel and the whole market falls while investors sort it out, Lampert loses money that quarter in his investments (it is bound to happen) or a fire at the Land’s End factory destroys the winter line and quarterly results are adversely effected etc, etc. There are dozens more but those are just a few I came up with without really thinking about it. All of these have no long term effect on SHLD but in the short term would be negatives to the price of the stock (not the value of the company). What should he do? If he reads news articles on SHLD he becomes more confused, one says buy, on says sell and a third chastises him for even buying it in the first place! This investor has probably become frustrated and sold for either a loss or no gain.

Now, investor #2 has held the stock for 2 years now. He sat back and watched during the summer and fall of 2005 when the stock fell from $160 to $120. As he looked at the company he could see no fundamental reason for the dip. Nothing had changed with SHLD and the reasons he bought it were still valid. This being said he decided people were wrong for selling and bought more during this drop (many smart Berkshire Hathaway (BRKA) shareholders did the same during the tech bubble in the late 90's and have been richly rewarded). The stock has since rebounded and broke through the $160 level up to the near $180 it stands at today. Why was he so confident? He bought SHLD not as a trade but as an investment. He saw SHLD as an investment in Eddie Lampert. He saw increasing profitability in retail operations and a growing cash hoard for Lampert to invest. Based on the 16 year track record Eddie has, that cash is in excellent hands. During the summer of 2005 none of these parameters changed and in fact he had good company as Lampert was in the market buying the stock with him!! The only risks to his investment are a fundamental change in the company’s prospects (retail operations cease to be profitable) or Lampert leaving (unlikely since he owns 60% of the stock). In this investors mind, bad news or an “analyst” downgrade that causes the stock to dip are no big deal since it then allows him to buy more at cheaper prices. All of the risks that investor #1 has are meaningless to #2. They make no difference to the long term prospects of SHLD only the price the stock trades at today. If he plans on holding this investment until one of those fundamental factors changes, the weather this winter which is negatively effecting investor #1, will be meaningless to him.

The shorter your time frame of any investment, the increased risk you face that elements having nothing to do with the fundamentals of that investment will adversely effect the value of it. As you lengthen your time frame you diminish the importance of these short term events (risk).

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