Monthly Archives: December 2013

Know your risk tolerance and limits when you invest!

NOTE: This article is still in draft form. Due to work and family obligations (ie lack of time), I haven’t had a chance to fully re-read and fact check it.

When I started investing back in college I would invest in individual stocks.  Now that I am older and have more responsibility, my risk tolerance has changed.  With a family to take care of, I can no longer take large positions in individual companies which are inherently more risky than funds like ETFs.

Back when I was single, I was invested mostly in individual companies.  During that period the “Great Recession” of 2008/2009 hit.  I was in companies which I thought were great, but they really got beat up by the market.  Seeing them go down in price, I kept purchasing into them.  I remember buying into one particular small cap company that was falling lightening fast in its stock price, but the company was still reporting earnings of around $2/share, while its stock was trading for as low as $4/share!

Four dollars per share on two dollars per share of earnings is an absolutely insanely low valuation for its “earnings per share” ratio, which is just 2 to 1.  In a more stable and normal market, companies will nominally trade for ratios of 20 or even 40 times their earnings. It was either an unbelievable discount or the company was going out of business!

Towards the end of the crash, my portfolio was down 75% and I was getting crushed.  It was, however, within my real risk tolerance that I could take at the time, because I was single and had no real financial responsibilities, other than to take care of myself.

I believed I was correct in my valuation of the company being worth much more than its then current trading price and I believed the market was wrong in the pricing of the stock, so I continued to purchase it as the price plummeted.

At that time, everything was just going haywire and nobody really knew what was happening.  The market was just crashing.

We all found out later that major funds and hedge funds had to indiscriminately sell everything to cover debts and short positions.  So everything got crushed, especially small capital companies, even if they were solid companies.

After all the financial shock issues finally shook out, that company returned to a more realistic valuation of 20 times its earnings and even shot beyond to somewhere around 40 times its earnings. I sold early at about 10x my cost, making 1,000% profit.

While its great to think back about the successful investment, I learned a lot about my risk tolerance that I would not want to learn at this point in my life, since I have a lot more responsibilities.

During that “great recession” crash period, I was down a HUGE amount in value and was EXTREMELY stressed out.  I wasn’t sleeping and was feeling fairly depressed.  The only thing that kept me together was my belief in my knowledge (which dwindled with every price drop) and my belief in the fundamentals.

I remember that to relieve my stress I would work out extremely hard (running and lifting weights).  One day I even distinctly remember thinking to myself “Is it a positive thing if I try to commit suicide by running myself to death?” because I figured I was taking a negative (committing suicide) and turning it into a positive (forcing myself to get into even better shape).

Because of that experience I really learned a lot about myself.  I thought I had the mental strength to handle the amount of decline I took, but I really didn’t and I know for sure that I could not go through that type of decline at this point in my life.

I’m much more cautious these days, primarily investing in Exchange Traded Funds (ETF) which are funds that hold a bunch of companies, usually all within a similar sector.

The reason I don’t invest heavily in individual companies is that even if I do all my diligence on company (looking at management, balance sheet, cash flow, etc.) there’s still the chance of corporate espionage and scandals.  Issues like Enron had where the company was doing insane things with their accounting, bookkeeping and reporting are happening more often (or so it seems).  A company could look great from all the business and financial views you can think of, but you can’t easily spot the espionage and scandals.  So I know that my current risk tolerance couldn’t handle losing a large position in a single company due to something like that and I stick with funds for a majority of my portfolio.

To sum up, if there’s a first piece of advice I could give a new investor, it would be to learn your risk tolerance and to be honest with yourself when you evaluate your tolerance.  Its one thing to believe you can handle a large decline in value, its another completely different thing when it actually happens.