Ep.101 - A 5-Point Guide to Evaluate Risk Level in Your Stock Investment

📸 IG handle: DollarSenseLA

WE ARE ALMOST CERTAINLY IN AN ASSET BUBBLE

The U.S stock market is almost certainly in a bubble. While tens of millions of Americans continue to be unemployed and GDP contracts by -9.5% in Q2, the largest drop in the recorded U.S history, the S&P500 (as of 7/27/2020) has climbed 40% from its year-low, now just less than 5% away from its record high. As Robert Schiller pointed out (quoted by Paul Krugman), a bubble is a natural Ponzi scheme, in which people buy because they know they can sell to the next person. But it stops abruptly when the next person becomes the last person.

I am almost certain this is what we are experiencing right now.

Source: Bureau of Labor Statistics

YTD S&P500 is fully recovered, just <5% shy of its peak. Source: the WSJ

However, being in the stock bubble does not necessarily mean the bubble will burst soon. In fact, whether the bubble goes on for 3 months or 3 years is anyone’s guess. The truth is, no one knows. If you are considering investing right now, it is imperative to recognize risks when you see them. Whether you decide to take on the risk or not will entirely depend on your personal risk tolerance.

WHAT IS RISK

Risk is defined as the volatility of a stock’s performance. In layman’s term, higher risks generally mean a potential for a higher return, but also the potential for a higher loss.

For example, a low-risk investment (think bonds) may go up by 3% when the market is up, -3% when the market’s down. The range is relatively narrow. On the other hand, a high-risk investment may have the potential to go up 30% (think Moderna right now), but it may also go down by -30%. The range is much wider. In other words, it is typically more of a roller coaster ride.

THE RISE OF ROBINHOOD DEMOCRATIZED INVESTING

Since Covid19, millions of Americans have opened new brokerage accounts to day trade. At the end of Q1, 4.5 million new accounts were created across Robinhood, Charles Schwab, E-Trade and TD Ameritrade. With E-Trade and TD Ameritrade in particular, new account signups were at mind-blowing 169% and 149% increase year over year.

Why did this happen now, not in 2008? On top of the rise of Covid19, a number of factors facilitated the mass participation of investing:

1. The ease of use via investing apps

2. $0 commission on trades

3. $0 minimum balance requirement

4. The fear of missing out leads to even higher participation

5. (Possibly) the cash injection from the stimulus package

Specifically, the creation of Robinhood (being at the vanguard on eliminating trade commission and minimum trade balance) provided access to investing for millions of Americans, who previously faced barriers to entry. For example, if a person had only $200 to invest back in 2008, one would not have been able to sign up for a brokerage account because $200 did not meet the minimum balance in the past (typically $500 or $1000). Moreover, each trade used to costs $7.99-$9.99 alone. After buying and selling 1 single stock (two trades), the person is already out $16.

BUT IT ALSO INTRODUCED MORE RISKS TO GROUPS WHO ARE LEAST PREPARED TO BEAR THEM

While the democratization of investing greatly benefits the general public by lowering barriers to entry, it has introduced risks to groups of people who are often least prepared to bear them, if the recession gets worse.

The recent brokerage account signups are disproportionally concentrated among millennials and Black Americans, largely because many couldn’t participate as easily in the past due to barriers to entry, particularly the minimum account balance, and trade commissions. If the stock bubble bursts in the near future, millennials, and Black Americans could potentially be the last group stuck with the risks with no one else to pass them onto, just like the last stage of a stock mania as described by Paul Krugman.

THE 5-QUESTION RISK-MANAGEMENT WORKSHEET

The tool below is not intended to provide specific investment advice on how to build a balanced investment strategy. Instead, it serves as general education on how to manage risks.

Before making a stock investment decision, one should assess and understand how risky it is. Then you can decide if you want to take it on or not. As an analogy, it’s similar to understanding food in terms of health. In order to decide if you should eat something, you probably should first understand how healthy or unhealthy it is. To do that, we use metrics such as fat, carbs, sugar, and protein as our tools. The worksheet below explains 5 metrics to help analyze risks in investing, analogous to the key metrics in analyzing food.

In reality, we may recognize a cheeseburger is unhealthy, yet still eat it. And that is okay. Investing could be the same, in the sense that people could still decide to take on risky investments. However, whether you partake or not, it is crucial to understand the risk objectively beforehand.

THE SCORING SYSTEM

Simply read through the following 5 points and see if you score a 0 or 1. For example, if your situation falls into the description of “Risk=1”, then you get 1 point. At the end of it, add them all up to see your final score, which ranges from 0 (not risky) to 5 (very risky).

SOURCE OF FUNDING

• Risk = 0: Ideally, you should only use the money you do not need (for at least 1 year) to invest. This means extra money outside of your monthly spending and the emergency fund (3 months recommended). I recognize the ability for someone to be in this position is a privilege of its own. If you are able to fund your investment with extra money, your risk is quite low, because even if you lose 80% of it, it will not impact your day-to-day living. If this describes you, mark 0.

• Risk = 1: If you use your emergency fund or borrowed money to invest, it is a risk you should be aware of because losing a significant amount could put you into debt. If this describes you, add 1 point.

  • If you have to borrow, the least risky form of borrowing is from funded sources, meaning you technically already have the money. For example, borrowing against your 401k is one relatively safe way of borrowing, because you already have the money. However, it does pose its own unique risk. If you are laid off or you quit, you would have to repay all of it at once.

DIVERSIFICATION

• Risk = 0: Ideally, you should not put all your eggs in one basket. In the world of investing, it’s called diversification. Practically speaking, at a minimum, I personally believe spreading the investment fund into at least 3-4 different uncorrelated stocks/ETFs. If this describes you, mark 0.

  • Buying 3 stocks in the same field is NOT diversification. For example, buying 3 oil stocks of Chevron, BP and Marathon is not diversification.

• Risk = 1: If you are investing all of your money in less than 3 stocks, this is a diversification risk you should be aware of. The reason is your fate is solely determined on one bet. If this describes you, add 1 point.

  • Here is the exception, if your one bet is an already well-diversified ETF (such as SPY), then it is not counted as risky, thus marking it 0 instead of 1.

PROFITABILITY (MEASURED BY EBITDA OR NET INCOME)

• Risk = 0: If your stock is profitable, then it is not as risky. The 2 common measures of profitability are EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and net income. Both tell the same story in general (detailed differences here). You can find both metrics easily on in the statistics portion of Yahoo Finance for free (using Google for illustration purposes below). Basically, if both numbers of your stocks are positive, mark 0.

  • (Optional) If you want to want to consider companies that do not yet have a positive EBITDA/net income, you can dig deeper into Free Cash Flow (FCF), a different perspective than EBITDA/net income, because it’s derived from the Cash Flow Statement (the flow of money) instead of the income statement (a snapshot in time). Simply put, while EBITDA/net income can be negative, this unprofitable company CAN have a positive FCF (think Box.com). If even this metric is negative, it suggests that it may be difficult for this company to turn profitable soon. If you want to understand FCF in full detail, take a look at this detailed chart comparison between EBITDA and FCF. Lastly, you can find a company’s FCF from the Financials section ( ->cash flow) on Yahoo Finance for free.

• Risk = 1: An unprofitable company today CAN turn into a profitable company tomorrow (think Amazon). But there is a risk because most don’t. In the long run, if a business never turns a profit, it will crash and burn. As a result, if both the EBITDA and net income are negative for your stock, then it is quite risky, so you should add 1 point.

  • If you want to learn more about the fate of the vast amount of unprofitable companies (particularly Pets.com) during the dot-com bubble, here’s a great article from Ted.

EARNINGS (MEASURED BY P/E RATIO)

• Risk = 0: P/E Ratio is the price-earnings ratio (price per share/earnings per share) of a company, also known as the “multiple”. In general, the lower the better. Unfortunately, there isn’t a golden number that separates what’s too risky vs. just enough risk. Nonetheless, we can use the S&P500 P/E ratio as a general reference. For example, the P/E ratio of S&P500 is 30.56 on 7/24/2020. In my own personal opinion (not investment advice), if an investment has a P/E ratio above 50, it is quite risky (for context, 10 years ago when I was in college, I was told anything above 20 was seen as risky).

  • For your own stock, you can find this stat from the statistics section of Yahoo finance for free (using Google for illustration purposes below). There are 2 versions of P/E ratios, the trailing P/E ratio (historical) and the forward P/E ratio (forecasted). I recommend using the trailing P/E ratio because it’s based on actual data compared to the alternative, the forward P/E ratio, which is largely an educated guess.

• Risk = 1: This is strictly my personal opinion (not investment advice). You should add a point if your investment has a P/E ratio over 50 or unavailable. An extreme example is Tesla. At the price of $1,539 on 7/27/2020, the P/E ratio is 801, indicating it’s most likely extremely over-valued, thus risky.

  • If a company is not yet profitable, then the P/E ratio is typically marked unavailable, because mathematically it would be negative, thus meaningless.

BOOK VALUE (MEASURED BY P/B RATIO)

• Risk = 0: P/E Ratio is a great indicator, but it is a useless metric on unprofitable companies because they do not have one. But these companies may have the potential to become profitable in the near future. As a result, to evaluate the riskiness of a company that’s not yet profitable, it would be good to consider the price-to-book ratio, which is the market value relative to its book value (basically the net worth of a company). Like the P/E ratio, the higher the P/B ratio, the riskier the investment is. There also isn’t a golden rule to tell what’s really risky vs. not. However, the S&P500 P/B ratio is at 3.5, perhaps a useful reference. In my own opinion, a P/B ratio above 5 is a red flag for high risk. You can find the P/B ratio from the statistics section of Yahoo finance for free (again using Google for illustration purposes below).

• Risk = 1: If an investment has a P/B ratio greater than 5, you add 1 point.

UNDERSTANDING YOUR RISK LEVEL

If your score is 0-2, you are taking on relatively low risk in your investments. You should not be too concerned.

If your score is 3, you are taking on a moderate amount of risks. You should be asking yourself, will your daily life be impacted if a sizable portion (say 30%) of your investments is lost in a downturn? If so, you may want to reduce risks.

If your score is 4-5, you are taking on a lot of risks. And that’s okay. A 4 or 5 does not mean you have to stop pursuing your investment opportunity. Why? Because a high-risk investment could go either way, resulting in high rewards or high losses. What I would recommend, is to take a day to fully process and acknowledge the potential risk with yourself, and make the decision next day, no matter what it is. If you do suffer a loss in the future, just know it will eventually bounce back over time.