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[sharechat] Risk vs Return

From: "" <>
Date: Tue, 08 Jun 2004 13:00:21 +1200

There are a lot of outspoken thinkers on this forum who put forward the 
view, either stated or implicit, that you will never get a decent return unless 
you are prepared to take a good deal of risk.

Taking an overview of the investment spectrum, I tend to agree with them.   
There is a fair amount of evidence out there that shares have 
outperformed property in the long term as an investment.  Likewise 
property has outperformed fixed interest investments.    

However if we try to take this 'risk return' theory to that corner of the 
investment spectrum we call 'the sharemarket' then the theory is on 
somewhat more shaky ground.    I refer here in particular to the more 
speculative shares that tend to get more than their fair share of limelight in 
this forum.

I'll cut here to an article that appeared in  Motley Fool in April by Matthew 


Beat the Market With Less Risk
By Mathew Emmert
April 12, 2004

This article has been updated since its initial publication on Dec. 1, 2003.

There's no question that dividend-paying stocks have been less volatile 
(read: less risky) than their stingier brethren over the years. In fact, they 
tend to contribute little more than 10% of the volatility of the market as a 
whole while producing market-beating returns. What's this? You mean you 
can get better returns with lower risk just by purchasing dividend-paying 
stocks? You betcha.

The standard line in relation to investment risk is that those who take on 
more risk are destined to receive more reward. While this is largely true, 
it's only true to a certain extent. We as investors have a tendency to 
dramatically over-estimate the amount of risk that's required to achieve 
respectable returns.

Indeed, at a certain point, each incremental unit of risk that you take 
actually produces a smaller amount of return. This is largely because, as 
you start to swim deeper and deeper into the risk pool, you have fewer 
winners and more failures affecting your overall success rate.

Unfortunately, there's no magic number that tells us when the additional 
return is no longer worth the risk. So, ultimately, we have to learn where 
that cutoff lies for us as individuals in order to maximize returns for the 
amount of risk that we're willing to take.

However, in investing it is often possible to dramatically increase our 
returns while reducing our risk by seeking companies that possess certain 
characteristics. And, to that end, it turns out that whether a company pays 
a dividend is a rather important characteristic.

The real deal

Do you need proof in order to believe that you can actually receive greater 
returns while taking on less risk just by investing in dividend-paying 
stocks? Well, BusinessWeek has pointed out that the return of the Nasdaq 
stock market, known for its healthy dose of aggressive technology stocks, 
actually underperformed the S&P Utility Stock Index from 1971 through the 
third quarter of 2001 -- 11.2% vs. 12%, including dividends.

Granted, the actual difference in return is modest, but the real importance 
here lies in the fact that the utility investors took on substantially less 
to achieve their return, making the difference on a risk-adjusted basis 
much more meaningful.

Indeed, the utility index beat the Nasdaq while incurring about half its 
volatility. The bottom line: During this period, Nasdaq investors were not 
adequately compensated for the amount of risk they took on, so don't take 
unnecessary risks in your portfolio. In the end, one could have achieved a 
higher total return, experienced far less price fluctuation, and maintained a 
substantially higher level of income by owning the boring, old utility index.

Several other studies bear out what we've seen here. Dividends have 
contributed 42% of the S&P 500's total return since 1926. That's right -- 
when it comes to that 10.2% S&P 500 return figure that everyone tosses 
around, nearly half of it came from dividends.

The income answer

I'm not saying that every stock in your portfolio has to be a utility or a 
dividend stock -- far from it. However, investors must always be conscious 
of the level of risk that they're taking to achieve their reward, and 
historically speaking, dividend-paying investments have offered the most 
compelling risk-reward trade-off available. Opportunities to achieve above-
average returns while taking below-average risk abound in this investment 

For instance, the best-performing investment selection for Motley Fool 
Income Investor has been Annaly Mortgage (NYSE: NLY). This company 
has returned 19.14% to our readers over the past six months, handily 
beating the 5.3% of its benchmark. Despite its increase, the firm still 
boasts a yield approaching 11%. The real story here, however, is that the 
company has produced its market-beating return while being only one-third 
as volatile as the overall market. So, again, on a risk-adjusted basis the 
return is much more favorable.

The same can be said for all of the newsletter selections thus far, as well 
as the stocks selected for the income-producing Six-Pack Portfolio on back in March of last year. Overall, Income Investor selections 
are doing 10.4% better than the market while being only 10% as volatile as 
their benchmarks.

The Six-Pack Portfolio, including investments such as BellSouth (NYSE: 
BLS), ConAgra Foods (NYSE: CAG), and Altria (NYSE: MO), has 
produced a total return of 45.5%, comfortably beating the S&P's 35.22%, 
and again, the Six-Pack has been just half as volatile as the overall 
market. I continue to favor this portfolio, and believe these companies will 
march higher in the years to come while producing substantial dividends 
for income-oriented investors.

Another important aspect of the income-investing strategy is that dividend 
payers tend to fall only half as much as non-payers in down markets, as 
they have their yield to help support the shares. There are a great many 
people who were wishing they had a few dividend payers in their portfolios 
when the bears came calling. If you and your stomach endured the wild 
rides of a Cisco Systems (Nasdaq: CSCO) or an (Nasdaq: 
AMZN) in the late 1990s, think about how much money you'll save on 
Maalox consumption once you're in solid, dividend-paying companies.

The Foolish bottom line

Identifying one's risk tolerance is a difficult process. Can I truly stomach 
the volatility of my investments? Am I OK with the idea that I could actually 
lose money? Can I survive that Mariah Carey concert? But the good news 
is that there's an entire investment approach that can keep you in the 
shallow end of the risk pool without drowning you in underperformance. 
Join the income investors (in fact, right now you can take a free trial) and 
fall asleep when your head hits the pillow.


I reproduce this article here because I am gradually shifting my own share 
portfolio towards more income producing shares.    Some would see that 
as more conservative.  Myself, I see it as more aggressive because I am 
moving my investments into shares that over time have performed the best 
of all.
The truth is I am probably becoming more conservative and more 
aggressive at the same time which kind of flies in the face of any 'risk 
return' share investment philosophy.

Of course fundamental to producing a dividend stream is that the 
underlying company must be making a profit.    I do find it amazing the 
number of people prepared to invest in companies that are not only not 
making any money but appear to be teetering on the brink of bankruptcy.  
Now I wouldn't deny anyone any speculative fun.  But I wonder how many 
of those investors know the risks they are taking?    The counter argument 
to this is that the speculative risks are worth taking to get the speculative 
rewards.   However, over the long term and using the S&P Utility Index vs 
NASDAQ comparison in the article I quoted, it seems that these 
speculative rewards do not exist.


discl: do not invest in shares without a profitability track record.

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on Pegasus Mail version 4.02
"Dogs have big tongues, so you can bet they don't 
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