Managing risk: expectations

The best way to manage risk in investing is by keeping your expectations low.

I am a big fan of investing. I think everyone should have a basic understanding of investing, and anyone who can should have some form of investments. It is a great way to get an extra income. As an employee (most of us make our living that way) you are always exposed to the risk of getting laid of. Who knows, maybe the company where you work goes bankrupt? If you earn some income from dividends in 10 different big and stable companies however, that risk is smaller. Basically all of them would have to go bust on the same day for you to be completely out of luck. For that to happen, things would have to get so bad that you would have bigger things to worry about anyway. So it is also a good way to diversify your risks, to own dividend-paying stocks in a basket of stable companies. So I tell my friends: own stocks, accumulate and buy more every year. Never sell, just wait for the dividends to roll in.

But what about the risks? What if the market goes down? What if there’s a stock market crash? They always ask.

That is, “what if stocks get cheaper?”

How could that be a bad thing? What if houses got really cheap? Buy another one, rent it out. What if stocks get really cheap? Buy more of them, collect more dividends.

(If you’re not sure about what a dividend is: A dividend is the distribution of a company’s profits, usually distributed again and again, every year, quarter or month. The dividend is paid to the owners of the company, in proportion to how many shares each one owns. If you buy stocks in a company on a stock exchange, you will become an owner of that company in exactly the same way that the founder or the CEO of that company might be an owner. You will receive part of the company’s profits in the same way as they do, in the form of dividends. A dividend is simply a sum of money that the company deposits into your account. You don’t have to sell any share to receive a dividend, it comes automatically. In fact, if you sell your shares you will stop receiving dividends because then you are no longer one of the company’s owners. There is no limit for how long a stock can be owned, it can be owned for a lifetime or get passed down through generations. The dividends received over all those years can add up to a considerable sum of money, or they can be used as an extra source of income, requiring no work what so ever. Dividends come from the company’s profits, not from the stock price, and not from the stock market. The price of a stock – its “performance”, “gains” or “losses” –  does not affect the amount of dividends the company pays.)

The price only matters to the one who buys and the one who sells. The seller wants high prices of course. Isn’t it to be expected that the buyer should want low prices then?

As long as dividends remain stable, lower stock prices is a good thing. If you’re not expecting to sell your stocks, that is. Lower prices means you can buy more future dividends for the same amount of money. And a company that grows (the company itself, not its stock price) will increase the dividends over time, without the need for you to buy more shares. There are many companies that haven’t cut their dividends in decades.

So why do we perceive lower stock prices as a risk rather than an opportunity? Because we expect to sell our shares in the future, to “get our money back“. So there is a very easy way to manage the risk of lower stock prices: Never be a seller. Decide from the start that you will not sell your shares, ever. Don’t expect to use stocks as a profit machine, but as a means of buying yourself a higher income.

Fundamentally, risk is the probability of unfulfilled expectations. Setting your expectations right is by far the best way to manage risk.