A light appears to be peeking through at the end of the tunnel for ASX shares and the broader market this year. The potential for interest rate rises to soon slow and stop has plenty of investors eager to dive back into the 'riskier' end of equities.
To illustrate, the tech-focused Nasdaq Composite Index (NASDAQ: .IXIC) and S&P/ASX All Technology Index (ASX: XTX) are up 15.6% and 14.8% respectively after a little more than a month. Meanwhile, the broader Aussie benchmark index has climbed a lesser 8.6% so far this year.
However, the early widespread strength might be somewhat deceptive according to one investment analyst. Instead, Dr Justin Koonin of Allan Gray Australia suggests a murkier future ahead as the heightened cost of capital canes the corporate world.
The changing environment renews the importance of what Koonin describes as a key factor for long-term outperformance.
Image source: Getty Images
Have you checked your weight (across ASX shares) lately?
There is a common misconception in investing that volatility is equivalent to risk. They believe the size and frequency of share price movements are where the 'risk' is for investors. But that isn't the case… remember we are investing in businesses, not tickers.
Here's an example case to look at to understand 'risk' across two scenarios:
- Company A is a profitable business with a history of growing earnings above 10% per annum with extensive cash reserves and no debt. The company is a microcap (~$100 million market capitalisation), has minimal market liquidity, and a share price that regularly moves 10% on the ASX in a single day.
- Company B is an unprofitable business with declining revenues and a high rate of turnover in management. The company's cash balance is dwindling while debts are rising. Company B has a large market capitalisation (~$2 billion) and is highly liquid with the share price relatively stable at around $3.
Although Company A might have a more volatile share price, the business itself is in a less 'risky' position than Company B.
Dr Koonin explains this further in a press release made earlier today, stating:
Most investors tend to think about risk in terms of volatility. But there will always be volatility, that's part and parcel of investing. We instead view risk as the potential for permanent loss of capital.
Careful stock picking can help mitigate the risk of permanent loss of capital. Outperformance over the long term does not solely depend on the stocks picked but also significantly depends on the weight of the stocks in the portfolio.
The key consideration for investors is to ensure they're appropriately weighted across their ASX shares based on this definition of risk. Essentially, a company you believe is ~80% likely to return 20% should hold a larger weighting than a company that you believe has a 5% chance of returning 100%.
Echoing Buffett in 2023
The commentary from Koonin on allocating capital based on the risk of permanent loss of capital is reminiscent of the great Warren Buffett.
The legendary investor and CEO of Berkshire Hathaway has long been quoted on his two key rules, "Rule number 1: Never lose money; rule number 2: Never forget rule number 1."
As ASX shares begin to pick up steam again this lesson in risk and capital allocation might be a timely one. As Dr Justin Koonin puts it, "You can outperform with a low hit rate if the upside of the outperforming investment is large."
