The Prudent Investor

Letting Dividends Do Their Work

Most Recent Articles

IBM Joins Dividend Champions
IBM joined the elite Dividend Champions with their dividend increase in May which completed 25 straight years of dividend increases. I look at whether or not it is time for dividend investors to add it to their portfolios.
4 ETFs for Dividend Growth Investors
There are ETFs that cover pretty much any groupings one can think of and that includes issues of interest to long term investors. I look at four ETFs that are geared toward the prudent dividend growth investor.
Mutual Funds and Dividend Investing
Dividend investing is not just for those who wish to actively research and select companies. Some mutual funds are focused on dividend companies and offer diversification to the investor’s portfolio.
 

Risk That Can Affect Your Portfolio

by George L Smyth

As dividend investors, there are numerous risks to our portfolio, even though risk moderation is an element of the strategy. Understanding risk, as well as what risks might affect us, is essential to our portfolio’s success, and there are ways to quantify that risk to better understand it.

When I worked for Space Telescope Science Institute our deputy director was John Grunsfeld.  He was a NASA astronaut who had participated in three servicing spaceflights for the Hubble Space Telescope and two other shuttle missions, logging over 800 hours in space and eight spacewalks.  He gave a talk that centered on risk, as a common question to him involved the obvious danger of his previous occupation.  The emphasis of the speech was that one needed to understand the factors inherent in what one is doing, otherwise the perception of risk can be exaggerated or underestimated.  This is definitely true when it comes to our portfolios.

We see the misperception of risk on a regular basis, like when one is afraid to fly despite it being one of the safest means of traveling.  It is essential to understand that there is risk in everything, but it is equally essential to understand that that risk should be measured against something known, so that one knows whether or not that risk is relevant.

One of the great strengths of dividend Investing is that it helps mitigate risk – I have made this point in the past and will certainly refer to it numerous times in the future.  However, it might be reasonable to question what types of risk we are seeking protection from and how important these elements of risk are to the well-being of our portfolio.

The two types of risk that affect the value of our stocks are systematic risk and unsystematic risk.

Systematic Risk

Systematic risk refers to the risk that is inherent in the market.  It is associated with macroeconomic factors that cannot be anticipated or avoided, such as wars or natural disasters.  Because it affects the entire market it cannot be removed through diversification.

Systematic risk falls into four categories - market risk, interest rate risk, inflation risk, and exchange rate risk.

Market Risk

There is a herd mentality within the market and we see it all the time.  A stock moves up, more people buy it, which in turn causes it to move up even more, so even more people buy it.  This also happens when a stock falls.  These movements flow through the market and affect it as a whole.  If Apple has a big tumble then the DOW falls, which affects the entire market, so your position with Joe’s Bank, which has nothing to do with Apple, declines.

Interest Rate Risk

Interest rate risk primarily (and severely) acts on bonds.  Bond prices are inversely related to the interest rate.  This is because when interest rates go up the investor can find a better rate of return somewhere else, so to compensate the bond price needs to be adjusted to stay competitive. 

Inflation Risk

Inflation risk directly affects fixed income securities.  Inflation affects purchasing power – what could once be bought with a certain amount of money can no longer be done.  When I was young I remember being given a dollar and told to get a gallon of milk and a loaf of bread – and bring home the change.  This is inflation, and why leaving money in a savings account, while safe, will result in a loss.

Exchange Rate Risk

Exchange rate risk affects companies that have exposure to foreign currency.  Each day the value of the U.S. dollar can rise or fall as compared to the currency of other countries.  So if the value of the dollar falls against the value of the Yen and a company needs to buy parts from Japan, then those parts will cost more.

Unsystematic Risk

Unsystematic risk is specific to the company or industry.  Examples of this might be business risk, legal risk, political risk, etc.  This type of risk can be abated through diversification, so holding a larger number of companies in one’s portfolio that are in different industries can be helpful in this regard.  That is why investing in an S&P 500 index fund is a good idea.

There are so many types of unsystematic risk that it makes little sense to bother delving into each one (who wants to read that book anyway?).  Every company and each industry has its own collection, and quantifying it is very easy, so I will move along.

Measuring Risk

Measuring risk is an essential aspect to understanding how much risk a particular security might be holding.  Above we have seen a quick overview of the types of risk one might expect to encounter, but quantifying the risk can get us to a bottom line number of exactly how risky things might be.

Measuring systematic risk is usually done through the capital asset pricing model (CAPM).  That is about all that I am going to say about the subject.  Although I enjoy numbers and working with mathematics, I appreciate that I am an outlier in this respect.  If I cannot offer a formula in plain text then it is assured that most readers will not care to try to decipher an image of the formula – that would be perfectly reasonable.  However, I will offer a helpful link for those who do wish to learn about the CAPM.

Although certain elements of systematic risk are less important to the dividend investor, he or she does need to keep market risk and exchange rate risk in mind, although an exact formula might not be readily at hand. 

As far as market risk is concerned, I think of companies that maintain a high price to earnings ratio (P/E) as being particularly susceptible to market risk.  This is because a high P/E means that the company is valued higher than others, as the expectations are much greater and higher earnings are expected. 

It is common to see that when a company’s quarterly report does not meet the elevated assumptions of analysts, investors leave in droves because they understand that their lofty expectations were not met.  This is noticed and followed by other shareholders, with the resulting lowering of the value of the stock.  For a good company this could actually be an appropriate entry point for the long term investor, if the behavior appears to be irrational when looking at things on a long term basis.  Securities that are expected to be held for years place less importance on the numbers of quarterly reports and the short term expectations of analysts than the long term prospect of the company.

As far as exchange risk is concerned, the more international exposure the company has, the more concerned one should be.  Manufacturing companies are especially susceptible to the ups and downs of currency exchange rates.  Trade wars can also affect the cost of goods that these companies use to make their products.

These two issues, market risk and exchange risk, are items to be aware of, but quantifying them are exceptionally difficult.  Even so, according to Reference for Business the shortcoming of the CAPM include seasonal fluctuations and day of the week fluctuations, and some argue that even the S&P 500 is not a sufficient proxy to test against.  The takeaway is that for the dividend investor, outside of realizing that international exposure increases exchange risk, we should lessen our concern with systematic risk as it is simply the risk of holding stocks in the first place, and concentrate on unsystematic risk.

The best way to quantify unsystematic risk is to look at the investment’s beta.  Beta measures the stock’s volatility as related to the market.  A beta of 1 means that the stock has the same risk as the market as a whole, a beta greater than 1 means the stock has more risk than the market, and a beta less than 1 means that it has less.  The market is usually measured by a broad collection, like the S&P 500 or Russell 2000.

How is beta calculated?  According to Investopedia “Beta is calculated using regression analysis” and is “the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period.”  Got that?  Neither do I.

Fortunately, Zacks has done the calculation, and whenever I can find a source that has already performed the work for me then it is golden.  For instance, the beta of 3M, a stock in my portfolio, can be found here.  Not only is this a handy page that offers the company’s beta, but it is accompanied by a graph that shows its beta over the course of the past five years.

If you want to delve further into the numbers then there are nearly 40 other factors (like P/E, PEG, price, etc.) that can be overlaid on the chart.

I will only mention VaR to be a bit more complete.  VaR stands for Value at Risk, and is expressed normally as a percentage chance of a percentage loss.  For instance, VaR might determine that a company has a 4% one month VaR of 3%, meaning that there is a 4% chance that the stock might decline 3% over the course of a month.

There is little need for the dividend investor to bother with this statistical risk management method, as not only does it depend upon a number of assumptions that make its accuracy questionable, but also it is primarily used for short-term horizons.  If you do wish to get this information then it has been calculated and is available at YCharts (an example for 3M can be found here), though this is a pay-for service, so keep that in mind.

Summing Up Risk

Understanding risk helps us create strategies based on our risk profile.  I have a fairly high risk tolerance, so it is fine for me to consider companies that ride the roller coaster of the market’s highs and lows.  My wife, on the other hand, gets nervous when she hears about declines that may affect her retirement portfolio, so to sleep comfortably at night she needs to stay with positions that smooth out these ups and downs.

The bottom line is to understand where your risk tolerance lies – it is different for everyone, and there is no “correct” answer outside the one you assign to yourself.  Then look for companies and funds that correspond to that risk tolerance.  If you are unsure where your tolerance lies then it is best to assume that it is low until you go through an actual recession, then reconsider.



This website is maintained by George L Smyth