Every since i was young, it is almost a truth that in order to have higher returns, we need to take higher risk…
Even the textbooks teaches it. I am going to perform a myth buster right here.
My argument would be that in order to have higher returns, you need higher financial intelligence. And in fact, when you have higher financial intelligence, you lower your risk.
Let me give you an example:
I always say that when you buy a stock, you are buying a part of a business. Using Value Investing, I will choose a business that has been consistently making stable and growing profits. Ultimately, when you buy a business, you want it for profits, don’t you?
So say, i find ABC Stock which had been consistently having Earnings Per Share of $2.50 every year for the past 10 years.
In the real world, there are many stocks out there that can do even better… Stocks like WMT, NKE, WFC, etc has been making consistent and GROWING EPS for the past 20 years.
Now, back to our example of ABC stock with consistent EPS of $2.50.
Say, i check the Price of ABC and it is $25.
If i were to buy one ABC stock today, what is my risk and what is my returns?
Risk is $25 (based on worst worst case scenario, which is unlikely if i choose it based on Value Investing Criteria)
Returns is $2.50/$25 = 10%
Analysing ABC as a Value Investor, i personally will not buy ABC at $25, because i am only interested in a return of at least 15%.
And as we all know, the market goes up and it comes down, and interestingly, in the short run, the stock price does not reflect its earning abilities. So as a Value Investor, i set an email alarm for ABC stock and one day, i receive email notification that ABC stock’s price dropped to $16.50 per share.
What happened? Why did it drop to $16.50? Ah… the CEO is sick and admitted to the hospital. And this has got nothing to do with how much the business is able to earn (when you choose a business that fits all the Value Investing Criteria.) By the way, this happens all the time…
What is my risk and returns this time if i buy it at $16.50?
Risk is $16.50 which is lower than $25. So this is lower risk, does that mean my return will be lower?
Returns is $2.50/$16.50 = 15.15%
The risk is lower, yet the returns are higher!
And this type of opportunities happen all year round when you are trained. So get educated and know that when you have higher financial intelligence, you get lower risks and higher returns.
To your dreams,