How "risky" is your portfolio? If you asked a group of retail investors what made a stock "risky", you might get some commonsense answers about business risks such as exploring for gold and not finding any or an exposure to falling iron ore prices. Perhaps they might mention something about the running of the business such as a high level of debt or missed revenue targets. You might hear that the stock price is too high or that there isn't any "margin of safety". Clearly "risk" in these evaluations is the risk of losing money if you bought the stock.

Turn to theories of portfolio construction and risk is something quite different. Here "risk" is how much the stock price deviates over time — regardless as to whether it goes up or down. If you strip out all the technical sounding stuff, the basic theory assumes that stock prices are predictable with a measure of "risk" being a variance around this prediction.

Portfolio theory allows calculations as to the effect of adding assets to a portfolio depending on the risk and the correlation of price movements with existing assets. Theoretically you can reduce the level of portfolio risk by adding stocks to it until it gets to about 30 holdings, which, incidentally, is widely quoted as the magic number of stocks you should hold.

As Nils Bohr, Nobel Laureate in physics famously said, "Prediction is very difficult, especially if it's about the future". Models based solely on past share price movements might (just) have something to tell you about the immediate future, but if you are investing in real businesses for the long term, it is real business risks that you have to worry about. When Warren Buffett was asked about how academics regarded his approach to investments, he claimed they said, "Well, it might work in practice, but it will never work in theory".

Foolish takeaway

Be careful if you hear or read people talking about "risk" in connection with investments. Real risk is the risk of losing money and, at the very least, you should try to understand why you are making any investment before you risk your money .

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Motley Fool contributor Tony Reardon does not own any of the shares mentioned in this article. The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

The post Invest better: what you need to know about risk appeared first on The Motley Fool Australia.

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Four years since the GFC arrived – and seemingly wouldn't leave – the global economy is showing signs of improving, particularly in the United States. Unemployment is falling. Production is on the rise. Debt is coming down. Confidence is going up. The improvement seems real. And I think it will continue.

Some of the best business minds actually expect an acceleration of sorts  in the US once the excess of empty houses is soaked up by new household formation. As the world's largest economy, the US has a massive role to play in pulling the rest of the world out of the economic mire.

We're optimistic Fools and I'd venture to suggest the improvement is a certainty, but the timeframe is the question. It was Keynes who said 'in the long run, we are all dead'. I hope to see at least a few more economic cycles before that point, but his message is valid.

What might stall or reverse this nascent recovery? Four threats should be kept in mind.

Petrol prices

A rising Australian dollar has cushioned the pain for Australian motorists who otherwise would have felt significant pain at the pump. Petrol prices are only a couple of cents higher today, than two months ago. The US, devoid of the currency benefits we've enjoyed, has seen its petrol price increase 10% over that same period.

The oil price continues to rise, and while it's always possible that the Aussie Dollar will increase further, recent reports suggest we might be seeing price increases of up to another 10 cents per litre in the coming couple of weeks.

With the world's economy still largely powered by oil, a sharp increase could still cause growing pains – and that doesn't allow for any geopolitical shocks that may arise out of the Middle East – an ever-present risk.

Europe

It feels like we've been talking about risks coming out of Europe forever, but that doesn't make the concerns any less valid. Fallout from a Greece default or some other cataclysm within Europe's banking system could deal the global (and likely the Australian) economies a body-blow.

Europe comprises a very large chunk of global consumer spending. A deep recession could substantially reduce the amount of global trade being conducted – and will undoubtedly have flow-on effects for other economies, not least the Chinese economy. Our links to the Chinese economy are obvious – and any reduction in demand for our resources could hit Australian GDP and employment.

Secondly, we could still wake up one morning to learn that global and Australian banks are more exposed to European assets than they assured us, especially given the interconnectedness of our global financial system.

Politics

The heading almost needs no explanation. We all know about the ructions in the Australian Labor Party over the past week and the simmering tensions over the past few months. Only an optimistic few are suggesting that we've seen the end of Labor leadership talk. Despite that, we have nothing on the currently dysfunctional United States polity.

When ratings agency Standard & Poors downgraded US debt last year, its reasoning was clear: "The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenge," the ratings agency wrote.

They didn't mince their words.

Facebook has a sign in its corporate headquarters that says "Move fast and break things." This seems fit for US Congress lately. And while it may be a good motto for a young technology company, it's an awful way to run a country.

Something totally unforeseen

Author James Fallows once wrote, "What looks like tomorrow's problem is rarely the real problem when tomorrow rolls around."

There will be another crisis, another recession, and another panic. Many, in fact. And all will have something in common: They will be caused, at least in part, by factors and events that no one is talking about today. Japan could not have foreseen the economic hit caused by its tsunami last year. No one can predict the actions of a rogue trader. Wars, earthquakes, oil spills, assassinations… no one predicts these things because they can't be predicted. But they can have a huge impact on the economy.

Warning of "something unknown" might seem like a cop-out when making a list of risks, but it's probably the most important risk to think about. This is the basis of Nassim Taleb's best-selling book The Black Swan: It's the events we don't think about, or those considered highly improbable, that inflict the most damage. If everyone knows something is going to happen, it's probably nothing to worry about.

Foolish take-away

Once you accept that there will be periods of weakness and recession ahead and that we probably can't predict what and why, it can actually be quite a calming realisation. You stop trying – in vain – to know all the answers. Instead, control the controllables, focus on what Steven Covey calls your 'circle of influence', and extend your investing horizon so that what seem like major economic dislocations become small bumps in the longer term trend. Then invest accordingly.

If you are looking for ASX investing ideas, look no further than "The Motley Fool's Top Stock for 2012." In this free report, Investment Analyst Dean Morel names his top pick for 2012…and beyond. Click here now to find out the name of this small but growing telecommunications company. But hurry – the report is free for only a limited period of time.

Scott Phillips Is The Motley Fool's feature columnist. You can follow him on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors.This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

The post The 4 biggest risks to the economy appeared first on The Motley Fool Australia.

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I think the time between Christmas and New Year is one of the best times of the year.

When I'm on holidays, this week is a great time to put my feet up, catch up on some reading, and reflect on the year just gone and the year ahead. If I'm working, it's usually a pretty laid back time; a good chance to take advantage of light traffic and an almost empty office to catch up on work and get ready for the year ahead.

A Happy New Year
With less on our minds and the calendar about to tick over to another year, our thoughts also turn to resolutions, or at least to those things we want to do differently, come 2012.

With that in mind, The Motley Fool is bringing you a 5 part series we're calling '5 Steps to Better Investing'. We'll cover 5 topical issues that we hope will help you make better investing decisions in 2012.

Step 1: You don't have to make it back the way you lose it
We're only human – and prone to the psychological challenges that come with the territory. Chief among them is an over-reliance on the immediate past, and the tendency to extrapolate the most recent past into the future. For many, that has meant a 2011 that went from bad to worse – and felt terrible.

Our human nature also puts unnecessary constraints on our investing. When a stock we own has fallen below our purchase price – or if we've made some money, has fallen from a recent high – we can tend to fixate on making that price a 'target price' of sorts. Whether we've made or lost money on that particular company, the risk is still the same.

When we invest, it should be the company and its prospects that are important. No previous price – or future hoped-for price – is meaningful for the company itself, nor for the company's customers or suppliers.

Let bygones be bygones
Our tendency to hold on to a company's shares 'until the price goes back up' is exposed as an understandable, but erroneous errand.

As investors in Billabong (ASX: BBG), Myer (ASX:MYR) and JB Hi-Fi (ASX: JBH) know, prices can fall precipitously when a company releases bad news to the markets. Once the price has fallen, however, investors need to put that loss to one side.

Painful and difficult, yes, but also very necessary.

The Motley Fool has long encouraged investing for the long term, with holding periods ideally measured in years rather than weeks or months, but we also know that vigilance is required. If your reason for investing in a company still holds true, and a company remains valuable despite the bad news, it might be time to hold, or even to buy more. If the investing thesis has been undermined by recent events, it may be time to sell.

Invest in your best ideas
With limited funds, an investment decision is no different from a weekly budgeting decision – investing in one stock means those funds can't be used for a different decision.

If I believe Company A has better combination of business economics, growth potential, management expertise and share price than Company B, I should buy shares of Company A (all else being equal, and taxes notwithstanding).  I don't expect I'd get much argument from anyone on that point.

Accepting that premise is one thing, but acting on it can be very different – especially when you already own one of the companies.

There is unfortunately no shortage of companies trading well below their January 1, 2011 share prices. Some are trading near two or three year lows. Others have had a stunning run over the past few years.

Reassess and take action
If you have shares in the former group, I would strongly encourage you to not hold those shares simply because you're sitting on a loss and you're planning to wait until the price recovers. Equally, if you've had a good run, don't sell simply because the price is up, or hold for the same reason.

Instead, subject your holdings – and prospective holdings – to the Company A vs. Company B test.

If the companies you hold are the best place for your money on that basis, you should consider holding with confidence. If they fail, holding on to them while you wait – perhaps in vain – for the price to recover, simply consigns your portfolio to continued underperformance.

Foolish take-away
The New Year gives us all a chance to reset our investing scorecard. I'm not suggesting that ignoring the past is a good strategy – far from it. Experience – even years like 2011 – is an important part of successful investing. Trying to divine success from periods as short as a single year will lead to a multitude of errors.

That said, the opportunity to mentally reset – to put the year just gone behind us – can act as a psychological circuit breaker. It's why many of us use January 1st as a starting point for New Year's resolutions.

As you enter 2012, remember to look at your portfolio with fresh eyes – and resist the temptation to stubbornly hold on to a stock just because 'it owes you money'.

Are you looking for quality stock ideas? Readers can click here to request a new free report titled The Motley Fool's Top Stock For 2012.

Scott Phillips is The Motley Fool's feature columnist. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson

The post 5 Steps to Better Investing appeared first on The Motley Fool Australia.

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In this space earlier this week, I outlined my reasons for taking a pass on the banks.

I'm not swearing off our banking sector forever, but I suggested that while current prices make the banking sector well worth a look, I wasn't sure that they were cheap enough to tempt me, given the headwinds currently facing the sector, and the inherent opacity of their books.

I have no reason to believe the bank bosses are being in any way irresponsible or taking unnecessary risks with shareholders' money, I just find it difficult to be able to assess the level of risk, both within the banks themselves, and increasingly with their counterparties spread around the world.

Following that article, one correspondent asked a simple question, namely:

'What is the alternative…What businesses are easier to understand, analyse and are less risky?'

It's a great question.

You can never eliminate risk in investing, so the questioner is right when asking about less risk, rather than no risk. The best we can do is plan for those risks we can reasonably expect and avoid companies whose risks we can't get a handle on.

Easier to understand…
The first part of the question is probably the simplest. The key question to ask is 'how does this company make its money?'

Banks take depositors cash, lend it to borrowers, and keep the differential between the two interest rates. So far, so good. To really get a handle on the business though, you'd need to know who they're lending to, how creditworthy the borrowers are, and how reliant their customers are on other financial institutions.

Contrast that with a company such as Domino's Pizza (ASX: DMP). The business model is pretty straight-forward. They rent stores, buy ingredients and turn those into pizzas that they sell for a little more than the price of the ingredients, labour and other costs. They also franchise stores, and pick up a cut of each store's sales.

Retailers are another example. As long as they keep their inventories under control, the operations are pretty simple to understand.

It's worth noting that 'easy to understand' doesn't mean 'always a great investment'… just ask those who bought Myer (ASX: MYR) shares in the float.

…to analyse…
I can't do justice to a topic as broad as investment analysis in one article – there are whole tertiary courses devoted to the subject.

There are a couple of starting points that can make your investing life easier, however.

The first point relates to the examples I just gave – there are no extra points in investing for 'degree of difficulty'. It's always much harder to analyse a business which has a complex structure, is in multiple categories or is in a highly technical industry such as banking or biotechnology where specialised knowledge is required. There's nothing wrong with just letting those companies go through to the 'keeper.

Secondly, look for businesses whose management team is candid about both the good and bad news. The ride might feel a little bumpier, but at least you're getting it straight.

Lastly, companies who have gone through structural changes or have made acquisitions can be tricky. Often it's hard to compare their financial statements from year to year to really get a handle on how the underlying business is performing.

…and are less risky
The Oracle of Omaha, Warren Buffett sums up risk beautifully in this short quote – "risk comes from not knowing what you're doing". Hopefully we've addressed that in the first two sections, above.

Buffett's quote can be applied to two key areas – business risk and investing risk.

The number one potential enemy of all businesses is debt. Used well, it can be an important source of growth funding, and can help businesses earn higher profits. Used recklessly or naively, it greatly increases the chance of a small setback becoming a company-threatening event.

It's very hard for a company with no debt to go out of business, and if it does, it happens slowly.

Investing risk comes from investing without doing your homework – from buying companies you don't truly understand, or whose business models are unsustainable, to simply paying too much.

Foolish take-away
If investing was easy, we'd all be on our super-yachts in the Bahamas or skiing St Tropez. Unfortunately it's not that simple. It can be incredibly rewarding, both intellectually and financially, if you are patient and invest in companies, not just stock symbols.

Investing is a game for the tortoises, not the hares – and you can avoid self-inflicted wounds by taking the time to really understand what you're investing in, and why.

Are you looking for more quality stock ideas? Motley Fool readers can click here to request a new free report titled The Motley Fool's Top Stock For 2012.

Scott Phillips is The Motley Fool's feature columnist. Scott owns shares in Domino's Pizza. The Motley Fool's purpose is to educate, amuse and enrich investors. This article authorised by Bruce Jackson.

The post 3 ways to lower your sharemarket investing risk appeared first on The Motley Fool Australia.

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Wouldn't it be nice if you could enjoy some upside leverage without taking on extra downside risk.

Before I tell you how I think one stock has a similar return risk to the Australian market, yet offers a higher probable return, let's refresh our beliefs on leverage.

The great thing about the leverage is it magnifies returns. That, as you know, is also leverage's worst attribute.

Leverage – the wealth destroyer
The over use of leverage, or margin, is the surest path to financial destruction. Very few ever enjoy the fleeting moments of leverage-boosted wealth. Even fewer get out with their skins when they have had 'enough'.

Leverage – margin or debt – is the number one destroyer of wealth, both personal and corporate.

When I last wrote about Argo Investments (ASX: ARG) I claimed it "delivers instant diversification and a shot at outperforming the market". These were high claims when diversification generally means investing in index tracking funds.

Before I up my Argo claims I should add that the diversification I'm talking about is Australian sharemarket diversification. A single investment, no matter the asset, leaves investors exposed to many other forms of diversifiable risk.

Double banger potential
Argo's price to book is still around 0.9. That compares very favourably to the historical average of 1.15 and high of 1.5. When the Australian market enters it's next bull cycle, Argo is highly likely to enjoy both a rise in its book value and price to book multiple.

Source: S&P Capital IQ

Argo is a leveraged play on the upside potential without employing leverage. It has a high probability of outperforming the S&P/ASX 200 index and therefore most fund managers over the medium to long term.

Naturally, there is some risk that it will underperform.

Show me the leverage
Argo has a long track record of outperforming the market. Though, like almost every successful fund does at some point, it has lagged the market for the last few years.

Here's how Argo has allocated two thirds of its portfolio.

Source: S&P Capital IQ

Investors in Argo are buying an Argo ASX index at a 10% discount to the S&P ASX index.

Foolish bottom line

Argo comes with many risks, including permanent loss of capital.

My view is that it comes with almost the same return risk as the Australian market yet with a higher probable return – due to the current 10% discount from book and 20% discount to average price to book. Academically impossible I know, but there you have it.

This article contains general investment advice only (under AFSL 400691).

Dean Morel is The Motley Fool's Investment Analyst. Dean has no position in Argo, and is now wondering why not. The Motley Fool's purpose is to educate, amuse and enrich investors. Readers can click here to find out one company Dean does own, The Motley Fool's Top Stock For 2011-12.

The post The upside of leverage without the downside risk appeared first on The Motley Fool Australia.

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