A Frank Discussion About What Could Destroy Your Wealth

“Andrew, is oil going up or down now? Should I sell my oil ETF?”

“I don’t know. How much were you looking to make and what’s your time frame?”

“I was looking for a 10% pop over the next few days and I’m down 18% now. Wait  let me pull up a…now I’m down 19%.”

“So…you were willing to risk 19% or more to make 10%?”

“Uhhh….I guess so.”

“Yes, you should sell now. Sell everything. And with rationale like that, NEVER trade again.”

That’s a real conversation I had with a friend a few weeks back. I get a call similar to this one about once or twice a month or an e-mail from a new Prosperity Dispatch reader in a similar predicament. I’m not normally such a jerk though (he just happens to be in a position to know better), it’s one of the worst feelings in the world.

But almost every time the situation is totally preventable. situations like this happen all the time. Recent market volatility and the growth of ETFs have helped create a generation of novice traders destined for failure. I’m not going to sit here and tell you I’ve never made this mistake either. Over a decade ago, I made this mistake countless times. But I’ve learned my lesson the hard way and hope you don’t have to.

Ruin or Reward: It’s Your Choice

That’s why I’d like to have a frank discussion about something barely ever talked about when talking about stocks or investments. During a bull market, no one even thinks about it. It’s the last thing on anyone’s mind when they think “how much will I make on this?” I’m talking about risk.

For every 50 people who ask, “How much am I going to make,” there’s only one or two who think “how much could I lose.”

That’s why only a small percentage of investors are successful. Only a few analyze risk before moving up and down. But at the end of the day, it’s one of the most important factors to consider when choosing an investment.

The Perfect Example

Just take a look at what is going on now in the markets. Safe is in and risk is out. That means safe things are expensive - too expensive in many cases, and risk is cheap. For instance, as we looked at the other day, convertible bonds are as cheap as they have been in nearly three decades.

Here’s the thing though, since risk is so cheap, the amount of risk has actually been reduced. Meanwhile, the upside potential has increased greatly. Remember the example from “You Should Be Getting Excited About 2009“:

The perfect example [of investor refusal to take risks] is in the riskiest of all assets, stocks on the TSX Venture Exchange. The Venture Exchange is home to all of the penny mining stocks and other venture stage companies which are the most speculative investments (a.k.a. the most likely to fail miserably) you can make.

It’s one of the few places you can earn quadruple-digit returns if you’re holding the right lottery ticket…err…shares of the right company.

Investors were looking for big returns and had a huge appetite for risk. And they gobbled up the risky stocks the Venture Exchange offered. The TSX Venture Index started the year around 2,700.

The flight to safety has absolutely destroyed this market. In July the index dropped to around 2,500. After the liquidity crunch rocked the markets in the fall, the index fell 700 marking a 74% drop for the entire index.

It’s even worse if you look at individual stocks. Dozens of the penny stocks which fetched $2 or $3 a piece a year or two ago are now trading for between 10 or 15 cents each. At the risk of being over simplistic, the downside has been slashed by 95% (assuming you buy the same number of shares) and the upside has increased exponentially (from 50% to 1,900%) if the fundamental situation has changed much at all like in gold stocks.

It has been an absolute slaughter for anything risky and investors are more risk averse than ever. But now is not the time shy away from risk, it’s the time to start taking it on.

Exciting Times Ahead

This is all why I’m extremely excited right now. We’ve recommended sticking to the sidelines and only wading into a few select areas since the middle of last summer. Now, that’s starting to change a bit. Hope for an economic recovery is declining rapidly and we’re getting very close to the time to start moving back into the markets strategically.

As long time readers can attest, I do my best to avoid fear mongering. I just don’t see it as a way to get much accomplished and it’s much more fun to look for the opportunities out there. When it comes to risk, however, there’s nothing more important.

Taking undue risks can, will, and has destroyed many fortunes over the years. By paying close attention to risk, your fortune doesn’t have to be one of them.  Always consider the downside risks, upside potential, and make them part of your plan.

Coming Clean

I’ve got to tell you it’s been a busy week. There is a mountain of reports on my desk from the biotech conference I went to earlier this week. I’ve been reading three or four hours worth of them every evening and researching a few of the ideas which seem to have some potential. What I can tell you with 100% certainty so far is that I’m incredibly excited by the changes coming to our healthcare system.

The world is changing quickly and with change comes uncertainty and opportunity. We’ll do our best to eliminate the uncertainty and uncover the opportunity.

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