Investment Risks That You Don’t See Coming
Most investors do some homework before buying a stock to avoid obvious investment risks. Typical analysis includes looking at company valuations and financial metrics, such as sales growth, price to earnings ratios, return on equity, dividend yield, and free cash flow. Another level of analysis looks at products, competition, and management team, and the final level of analysis looks at chart patterns to see whether institutional money is flowing into or out of the stock.
Sometimes, you do all the analysis and still get blindsided
Investors were blindsided this week as fears of the newest Coronavirus (COVID-19) spread worldwide. The S&P 500 declined 12% over the past six trading days. Is this an over-reaction? It is too soon to tell. Epidemics of the past 100 years were brought under control relatively quickly and any impacts on global economies were short-lived. Nevertheless, the market hates uncertainty. In fact, the market was not at all bothered by the severe (common) flu season we are having (26 million cases, 250,000 hospitalizations, and 14,000 deaths in the U.S. through January of this year). However, COVID 19, which is estimated to have fewer than 100,000 cases and 3,000 deaths (worldwide) is having a much bigger impact on global economies because doctors do not fully understand how contagious it is, how far it will spread, or how many deaths it will cause. (Read: How does the new coronavirus compare with the flu?)
Past epidemic effects on the stock market
How do you manage the investment risks of unforeseen events, which may affect your stock holdings?
First, you need to differentiate between company specific risk (e.g., VW emissions scandal) and systemic market risk. Then follow these principles:
1) If you are still working, continue adding money to your portfolio through systematic contributions to your 401k. This will enable you to buy more shares as prices decline and subsequently benefit when prices rebound.
2) If you are retired, you should have 3-7 years’ worth of distributions not invested in the stocks (e.g., bonds, CDs, annuities, or cash). This “safe” money funds distributions so you can continue to live your same lifestyle, while giving your stocks time to recover. This is a cornerstone principle of Surevest’s PASS and Income Now portfolio models. The recovery in stock prices often happens in a matter of a few weeks, but sometimes takes months or even years.
3) Position size. A single company’s stock should not make up more than 2-4% of your portfolio and typically 1-2% is more prudent. Also, you do not want too much exposure to any one industry because all firms in an industry can be affected by certain events (e.g., travel or transportation companies by a global flu pandemic).
4) Favor for companies/industries with low regulatory or supply chain risk. The Clorox Company is a good example of a company with low supply chain risk. It has 13 suppliers, and not one of them accounts for more than 1.1% of cost of goods sold to Clorox.
5) Consider the opportunities that these unforeseen events can create. For example, one of the immediate beneficiaries of the Coronavirus scare are companies that enable workers to telecommute, such as Zoom Video Communications. Other companies and industries may be trading at bargain prices, where there is more upside potential at these prices than downside risk. The same is likely the case with ServiceNow, Inc., which has a focus on workflow automation. Many companies will experience lost sales, and their upper management will want to make up for it by increasing profit margins. That means increasing worker productivity through automating workflow, which should boost revenue for ServiceNow.
At the end of the day, you have to do as much homework as you can on your investments before you buy them, but realize and accept that the biggest driver of future prices is information that cannot be priced in today. The goal of investors should be to have more winners than losers and have the size of your winning investments outweigh the size of your losers.
Every portfolio has some investments that won’t work out as expected, but that’s okay. Just remember that even the great Michael Jordan only made 58% of the shots he took (including free throws), and he had a pretty good track record.
Some Surevest clients and employees may own some of the stocks mentioned. This article is for informational purposes only and not a solicitation to buy any of the stocks listed. Speak with your financial advisor before making any investments. Surevest Wealth Management is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Surevest Wealth Management and its representatives are properly licensed or exempt from licensure.