Risk versus Reward
I personally think that risk versus reward in investing is somewhat like the picture below. The three skiers are climbing up the mountain, which involves actual and perceived risk of injury. But the reward is getting to the top and enjoying the view and being able to ski down. Since I love to ski the risk is well worth the reward in my mind. However, that is obviously not the case for everyone. My wife would not climb the mountain to ski down since she finds skiing marginally enjoyable.
Similarly, investing involves balancing risk versus reward. Each person has their own risk tolerance balanced against a perceived gain for the reward or return. What is risk though in investing? That is a somewhat tricky question because sometimes it depends on who you ask. FINRA has a broad definition of risk:
“Risk is any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.”
I find that definition a bit too broad for me. But for many people risk means loss of capital of initial principal. This is often unacceptable and something most people want to avoid. There are other types of risk including volatility or market risk, business risk, concentration risk, and liquidity risk. These are much easier to quantify. For example, volatility can be defined by beta or standard deviation. However, there are yet other types of risk. There is the risk of outliving your savings, and the risk of not keeping up with inflation leading to a lower standard of living. These risks are harder to quantify. There is also the risk of Black Swan type events, such as COVID-19, which are living through now.
Almost all investments come with some type of risk. Some investments address some types of risk but in doing so have exposure to other types of risk. For instance, FDIC insured savings accounts or certificates of deposit (CDs) are thought of as risk free. In the sense that the principal is insured they are. However, this type of risk insurance comes with a different type of risk. The interest rates tend to be very low and hence there is inflation risk. The savings account or CD may not have a high enough return to keep up with inflation. Over time this would lead to a lower standard of living, especially in retirement.
In investing there is almost always a tradeoff. The higher the expected return or reward the greater the risk. For instance, in stocks one can lose your principal. This type of risk is one that most investors wish to avoid. Even blue chip or large companies are not immune. Investing news is now talking about some retailers and restaurant chains that are declaring bankruptcy, e.g. JCPenny (JCP), due to the COVID-19 pandemic. In some of these cases, equity holders will be wiped out during bankruptcy proceedings meaning they will lose their initial investment.
However, the higher risk comes with higher expectation and possibility of reward. Over longer periods of times stocks are expected to outperform less risky investments like cash or even U.S. government bonds or some corporate bonds. The table shows the trailing returns since 2005 of different types of select investments. You can see the point that I am trying to make. Stocks have a higher annual average return, but they also had the worst losses in a given year. On the other hand, cash had an annual return lower than inflation but even in the worst year the principal was still safe. High yield bonds and high grade bonds were somewhere in between stocks and cash.
|Large Cap Stocks||9.0%||32.4%||-37.0%|
|High Yield Bonds||7.1%||57.5%||-26.4%|
|High Grade Bonds||4.2%||7.8%||-2.0%|
So, what are investors to do short of being in all cash? In my personal opinion one should be diversified even in dividend growth stocks. Having all your eggs in one basket is too risky. One only has to look at some companies that faced large stock price declines due to business risk or technological obsolescence e.g. Eastman Kodak (KODK). How many stocks are enough? There is a lot of academic research in this area that you should take a look at. But one also has to balance the time and effort involved. I personally like 15 to 25 stocks. In this way even if one stock has a negative surprise event, I am somewhat diversified. Just remember though investing always involves risk.
Coronavirus Dividend Cuts and Suspensions List in 2020
I updated my coronavirus dividend cuts and suspensions list this past Wednesday. The number of companies on the list has risen to 282. We are now at over roughly 9% of companies that pay dividends having cut or suspended them since the start of the COVID-19 pandemic. Only five companies were added to the list this past week. This past week I added Buckle (BKE), Elmira Savings Bank (ESBK), Invacare (IVC), Abercrombie & Fitch (ANF), and Flexsteel Industries (FLXS) to the list.
Lastly, I will have an article on Southwest Airlines’ (LUV) dividend suspension on Monday. The airline has experienced tremendous growth since its founding. Today, Southwest Airlines is the largest airlines in the U.S. by number of passengers carried. The stock was also a dividend growth stock having paid a growing dividend for eight consecutive years. This made Southwest a Dividend Challenger. But COVID-19 has severely impacted air travel. In some weeks during the depths of the downturn airline travel was down over 90%. Check my blog on Monday for my article on Southwest’s dividend suspension and some discussion on when the dividend will be reinstated.
Stock Market Volatility – CBOE VIX
The CBOE VIX is now below 25 and still trending down. The long-term average for the CBOE VIX is 19 or 20. Hence, the current reading is a very good sign from the perspective of market volatility.
Greed Is Back – What’s the Risk versus Reward?
I have also been tracking the Fear & Greed Index. It has been roughly between about 40 to 50 for the past several weeks in Fear. Last week it was inching over 50. Now it is full in Greed at a reading of 66. A lot of this has to do with more advancing issue volume than declining issue volume in the market, a lower spread for junk bonds versus investment grade bonds, and surge in the S&P 500.
The NASDAQ-100 is trading at near a record high on the strength of mega capitalization tech stocks. Amazon (AMZN) is trading near its 52-week high. Microsoft (MSFT) is trading near its 52-week high. Other tech stocks have rebounded off their lows and trending higher. This has reignited Greed in my opinion.
With that said, if you look at the history of Fear & Greed Index, it is rarely over 60 for an extended period of time. A value over 80 usually occurs for only a very short time period. Read into that what you will. But with the S&P 500 trading at a price-to-earnings ratio of 22.9X and the Schiller P/E Ratio at about 30X, an argument can be made that the U.S. stock market in aggregate is overvalued as of this writing.
Secret Dividend Millionaires – Kathleen and Robert Magowan
In this installment of Secret Dividend Millionaires, I want to talk about Kathleen and Robert Magowan. They were twins who in their later years lived together in their parents’ house in Simsbury, Connecticut. The house was roughly 100-years old and was not renovated.
The twins died within a year of each other, Robert in 2010 and Kathleen in 2011. Neither twin was married or had children. They invested in stocks, bonds, and war bonds and grew their combined fortune to $10 million. Kathleen Magowan donated part of the fortune to a local elementary school, college, nursing home, and church.
Kathleen Magowan did not have a particularly high paying job. She was originally a nurse but switched careers to teaching after getting her master’s degree in education. But she lived a frugal lifestyle and had no family. This likely minimized her expenses. She also inherited the family home from her parents, which meant that she had no mortgage. This was major advantage for her in building wealth as a mortgage is the main expense for many people.
Her twin brother, Robert Magowan, was a Prudential insurance agent. He reportedly had a knack for investing and made many of the investing decisions. He made the decision to invest in Ametek Inc, and Pennsylvania-based electric motor, pump, and instrument manufacturing company. This stock ended up being Kathleen’s biggest winner. Seemingly, this was one of those companies that no one just goes out and buys. So, Robert must have done the research to make the decision.
In the end the combination of frugal living and good investment decisions seems to have allowed the two siblings to amass a combined fortune of $10 million. They had little in the way of expenses and probably a high savings rate. The lesson learned is that one never knows what people have in the way of assets. How someone lives is not necessarily a reflection of their wealth.
You can read about the other Secret Dividend Millionaires.
Here are my recommendations:
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.