Higher Complexity or Risk Does Not Mean Higher Returns

In my last post, I discussed about how I dealt with my existing position in some of the dividend cutters. I received a question that “can your post be interpreted as a recommendation to buy BAC and WFC because they are cheap”, and “what about GE, doesn’t it have wide moat, you ignored GE and did not mention anything about it”.

To begin with, this blog is not about recommending any stock or advising what do with individual’s investment. I have mentioned this in my disclaimer. This blog is a chronicle of my quest to build an income portfolio. I do not recommended or advise buying any stock on this blog. The premise of the post was how I dealt with the dividend cutters in my portfolio. It was about risk management process for my own dividend growth portfolio. It demonstrates my thought process with reference to my principle of objective based investing approach. I added to my original position based on my personal risk profile. I did not initiate a new position.

For example:

  • An investor buys 10 shares at $10 per share. His total investment is $100.
  • The share price drops to $1. He could either get rid of them by selling, or buy more, or do nothing.
  • Selling results in loss of $90. In my opinion sometimes (not always) no action means taking loss. No action should have some reasoning.
  • But if an investor’s risk profile allows making additional small investment, then he/she can buy additional 10 shares at $10 only. Now the investor has 20 shares for $110.
  • If the company is not going away, it will come back to some higher value. Say $3. His loss is now only $50 (110 – 3×20).
  • If the company is going bankrupt, investor will loose additional $20 only. I added $10, and I lost the opportunity to get $10. Remember by selling he has already lost $90.

At this point in time, I find that all three companies (viz. BAC, WFC, and/or GE) very complex to understand. I find it hard to figure out:

  • What is their true value?
  • Are they going to go bankrupt? or will they be nationalized?
  • How real is their balance sheet? The most recent EPS appears to be paper profits? Where is cash?
  • If we look at the EPS, most of the business units are negative, or showing reduced income?
  • If in fact these companies were making real profit, why not reinstate dividends? E.g. GE is hoarding USD 30+ billion cash? Why?
  • Will the integration process of acquired companies work?

There are many more such questions which I cannot understand. It is difficult for me to make a qualitative analysis. Suffice to say these companies have become very complex to really figure out what they are doing. The story keeps changing every month.

There is a saying about risk and return. The higher is risk the probability of “returns are higher”. It does not mean that higher risk (or complex risk) “increases the probability” of higher return. The implied meaning is “probability of higher return” is much lower.

The point I am trying to make here is risk (complexity) / return is not that simple. Higher risk definitely means higher return. But then a chance of that higher return also diminishes. Then why chase it? Why not go for less risk and less return (and better change of good return).

Just because these stocks are dirt cheap, I would not initiate any new position in these three companies. They are dirt cheap for a reason. There are other better opportunities to go after and these three companies

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