4 warning signs that you’re taking too much risk when investing...

Some people like to take risks. Sky divers, racing drivers and people who swim with sharks come to mind. But I’m guessing you didn’t start investing just to take risks.

In fact, you’d probably prefer it if the risks weren’t there at all.

And that’s entirely reasonable; after all, why should you take risks with your hard earned money that you don’t have to?

The problem is, most active investors are taking risks that they don’t even know are there and so when things turn nasty, they panic and do exactly the wrong thing.

Warning #1 – You’re worried about how the Euro Crisis will affect your investments

The first sign that you’re taking on too much risk is that you’re worried about what’s going to happen tomorrow. You’re reading the papers, watching the news for every little scrap of information. Not out of any great love of our 24-hour media machine, but out of fear.

Fear that the Euro might break up. Fear that Greece might be kicked out. Fear about the recession. Fear about the latest US jobs report. Fear about Chinese economic dominance.

Now, don’t get me wrong. It’s fine to fear these things for a hundred different reasons, especially if your job or business will be affected by how they pan out. But if you’re investing in the stock market for the long-term then what’s happening today should, short of nuclear war, not keep you up at night.

If you’re sceptical, then that’s just natural, but remember – most academics think that a passive index tracking strategy is the best way for virtually everybody to invest. Passive index tracking takes absolutely zero notice of the news, the economy or the Euro Crisis.

And yet, such an ignorant system manages to beat most active professional fund managers, and they in turn manage to beat most of the private investors who invest with them.

Passive indexing shows that you just don’t need to watch the news or your investments like a hawk to make a fair return.

Solutions: Stop reading so much news; review how long you have until you need to sell your investments; reduce your exposure to the stock market.

Warning #2 – You’re worried every time the market drops significantly

In early May the FTSE 100 reached 5,800 and yet in just a couple of weeks it fell to less than 5,300. That’s a drop of almost 10% and was enough to spark off another round of media fanfare with headlines like “FTSE falls again on Greek woes” and “FTSE falls to new six month low”.

I’m sure those articles were very interesting, but I’m not so sure they’re of any use to long-term investors.

If you’re investing for the long-term then short-term falls in the FTSE shouldn’t be important. If you’re not investing for the long-term then you shouldn’t have much, if any, of your investments in equities. It’s as simple as that.

But unfortunately that’s not how it works in the real world – active and passive investors alike really are scared of falling markets, even if they have long investment horizons.

One of the main reasons for this is that they don’t really understand what the market is, or how its market price relates to the real companies that the FTSE 100 represents.

When the market tanks by 50%, as it more or less did between 2000-2003 and again in 2007-2009, it’s reasonable to be scared. If you were 100% in equities at the time it takes a very stoic nature to just shrug off a 50% decline.

The problem is that people don’t realise that the market never goes to zero, and it doesn’t go to infinity. The market is a range-bound beast and it gyrates around some central value which is directly related the the underlying asset, i.e. the 100 largest companies in the stock market, in the case of the FTSE 100.

So if the market falls from 7,000 to 3,500, it’s easy to think that it will just keep going down, to 2,000 or 1,000 and, although small, there is a chance that it could do just that. But if it did it would be like somebody offering you a brand new Rolls Royce Phantom for £50. The price may have changed but the underlying asset has not.

Solutions: As before, stop reading so much news; review how long you have until you really need to sell your investments and think about the relevance of the 10% fall in the last two weeks in comparison to the next 10 or 20 years; reduce your exposure to the stock market.

Warning #3 – You’re worried when one of your stocks falls off a cliff

Enough about the market; let’s get down to specifics. You’re a stock picker, you like to invest in individual companies so that you know something about where your money is invested and so that you have a chance of beating the market.

But something’s wrong. One of your stocks is down 50% and it just keeps falling. Unlike the market as a whole, individual shares do go to zero and in the last few years they’ve been doing it with frightening regularity.

This fear of a price fall in the value of one company’s shares is much more reasonable than fearing a falling market. But it is still a warning that you’re portfolio isn’t properly aligned with your risk tolerance.

The first thing to note here is that individual shares are much more volatile than the market as a whole. Falls of 80% or more are not that uncommon, even in robust and financially strong companies. It’s essential that active investors understand that shares are volatile, even if there is no significant news about a company.

There are essentially two warnings that are being given when an investment falls and you break a sweat.

Firstly, it’s a warning that you have too much money in that company. You aren’t diversified enough in other words. Most active investors hold a very concentrated portfolio of just a handful of companies.

If you have 20% of your money in one company and the shares fall 50% then you’ll be down 10% from just that one investment. And given that it’s an individual company, there is the possibility that it could go to zero and lose you the whole 20%.

If on the other hand you have no more than 1%, or 3%, or even say 5% in any one company, a drop of 50% in that one investment will only cause you a 2.5% loss at most which is far less scary.

It’s fine for somebody like Warren Buffett to say that diversification is for people who don’t know what they’re doing; but for the average investor, even the average stock picker, being sufficiently diversified is about the most sensible thing they can do.

The second warning this fear is giving you is that the company you’re invested in may just be too risky for you.

Unless you’re very diversified, holding perhaps 100 companies like a passive investor holding the FTSE 100, then a good way to reduce this fear is to only invest in very robust, very high quality companies.

When Tesco shares dropped by almost 25% in a couple of weeks, the market saw a perfect example of how a large, high quality company can drop like a stone.

However, a good investor like yourself would probably ask if it was reasonably possible for a multi-billion pound, market leading supermarket to actually become 25% less valuable in a two week period, just because it had some relatively poor trading figures in a single year.

The answer is that it probably didn’t, and that knowledge can make it easier to ride out this sort of short-term setback until the market cheers up and re-rates the company accordingly.

Solutions: Be more diversified; only invest in robust and high quality companies.

Warning #4 – You’re worried when one of your stocks issues a profit warning

This is closely related the the last warning, but instead of worrying about what the market thinks, this time you might be worrying about the company’s weak annual results (or if you really like to worry, its interim or quarterly results).

If you find yourself watching the news feed on your investments to see which director has joined or left, which contracts have been signed and what colour braces the chairman is wearing today, you’re probably overdoing it.

Of course, some people like to keep up to date with every snippet of news and like to know everything about their investments, but it just isn’t necessary when you invest in the right sort of companies.

In some cases, keeping up with every move, every second is important. In my time I’ve invested in two companies that went bust, and in both cases I found myself hunting for news about how these companies were negotiating with the banks to change their repayment agreements.

By sticking to market leading, financially strong companies, you give yourself a much better chance of riding out any bad news without selling at the bottom. By investing in companies like Tesco, it’s much easier to see that it’s very likely to still be here in 10 years and so poor results in any one year are unlikely to make much difference in the long run.

Solutions: Be more diversified; only invest in robust and high quality companies.

I plan to expand some more on these themes of risk control in the near future, going into a bit more detail on some different approaches to staying sane in the stock market.

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