realizedhow risky the entire matter was. This history has relevance today.Most investors know only about the most obvious form of risk,called ‘‘market risk.’’ This is the risk in losing value due to a declinein a stock’s market price. However, many other forms of risk needto be examined in order to compare opportunities in the market.Risk also extends to economic factors; for example, utility companies’ stock value is affected directly by interest rates because utilitiesrely heavily on debt capitalization. A speciﬁc sector also may becharacterized by certain identical risks, such as sensitivity to interestrates or common trends. Thus, the investor needs to study risk fromthe larger view to ensure that risk is either minimal or that differentrisks are spread among dissimilar issues.Risk management in this sense may also be termed ‘‘opportunitymanagement,’’ because risk and opportunity are different aspects ofthe same condition. A change in risk posture often ﬁrst shows up inearnings, followed by changes in dividend yield. Thus, risk adjust119
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ments also serve as a form of primary movement or change in astock’s trend; for example, the practical application of the DowTheory.
Lessons to Be Learned from HollandIn the 1630s, nearly 400 years ago, an odd occurrence in Hollandprovided a valuable historical lesson. Speculators invested literallyfortunes in single tulip bulbs as a market went crazy—prices ran upand common people became rich—and then the whole thingcrashed and all of those fortunes were lost.This strange event, known as tulip mania, was short in duration,but holds valuable lessons for every investor today. It demonstrateshow crowds think and how both greed and fear dominate any market where money is involved.By their nature, tulip bulbs are scarce. From a seed, it may take5–10 years to produce a ﬂower, and another 3–5 years for it toevolve into a ﬂowering bulb. Rarity is further deﬁned by the colormarkings in variegated tulips. Ironically, these colors are the resultof viruses that reduce the number of offsets, making them evenmore rare. In 1635, an important change occurred in the tulip market. Rather than selling ﬂowering bulbs once produced, the marketbegan trading in tulips while they were still in the ground, and a lotof this trading took place by promissory note rather than an actualexchange of cash. The market evolved into a type of tulip futuressituation. Speculation regarding time to maturity, weight, and quality often created several hundred percent growth in value, so thatspeculators saw great potential in this futures market. By 1636, themarket itself had grown considerably following a year of depressedprices, and many more people could afford to get into the tulipspeculation business.As many speculative markets do, this one accelerated to thepoint that prices rose to irrational levels. To provide some perspective on the wild speculation, a 1635 sale of 40 bulbs went as high as100,000 ﬂorin. In comparison, one ton of butter was worth 100ﬂorin. Some bulbs, like the best-known and most sought-after
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Semper Augustus, were sold for as much as 6,000 ﬂorin (over$4,000) for a single bulb.The market became so exaggerated that traders began sellingtulips that had only recently been planted and even made sales fortulips not yet planted, a dubious move called windhandel (windtrade). But by the beginning of 1637, the speculative bubble hadreached its peak and prices would not rise any further. As it alwayshappens, the entire bubble burst quite rapidly and suddenly, manyholders of futures contracts discovered overnight that their speculative holdings were worthless. Thousands of investors, traders, andspeculators lost everything.The obvious lessons gained in hindsight are clear. Speculatorsof the period mortgaged their homes to get into the game and committed themselves to unimaginable debt, all in the belief that theywere going to get rich. Three of the important lessons are:1. Irrational speculation never anticipates the end. This occurstime and time again. Few speculators, in the middle of a speculativefrenzy, stop to think about the actual risk they live with, and virtuallyno one who is making big proﬁts wonders about when it will allend. Most speculators merely assume that they will magically knowexactly when the market is about to crash, and plan to get out rightbefore that happens. But it never works that way.2. Few speculators set prices for themselves to take proﬁts andget out. The ‘‘greed factor’’ in speculative frenzies dominates peopleand the way they think. Surely everyone has heard the clear-headedand rational advice to set goals, and when those goals are reached,sell and get out. It would be smart to do so, but it doesn’t work intimes of manic speculation. The only fear speculators have at thetime is that they might get out too early and miss out on even moreproﬁts. So instead of saying ‘‘I will double my investment and thensell,’’ it is more common for speculators to churn their proﬁts intoever-higher levels of risk. Thus, even with amazing proﬁts in hand,the tendency is to leave it at risk until the inevitable 100 percent lossoccurs.3. Logic goes out the window when proﬁts appear easy to make.The very fact that speculative bubbles exist turns otherwise logical
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and even cautious investors into irrational, greedy, and ‘‘blind’’speculators. During tulip mania, many people who had never invested before put all caution aside and made vast fortunes on paper,took those proﬁts, and reinvested them into more future holdings,apparently oblivious to the potential risks. There is something abouthuman nature that allows people to put logic aside when potentialriches appear, and to suspend risk tolerance standards to chase easymoney.The historical events of tulip mania demonstrate how people actin any market where money exists. The primary human emotions atsuch times are greed and fear. Greed allows people to see no end insight to their proﬁt potential, right up to the point where it all evaporates. Fear replaces greed overnight, and is equally irrational.The value in remembering tulip mania is that in the stock market, this kind of illogical activity—ruled by greed on the way in andby fear and panic on the way out—is possible today. Yes, even withthe vast free information on the Internet and sophisticated tradingsystems everyone hears about, greed and fear remain the primaryemotions in any market, most notably the stock market. Even so,perceptions about market troubles can also be irrational. For example, the cyclical real estate market in 2005 and 2006 was said to bein a speculative bubble that was about to burst. In fact, actual bubbles existed but only in isolated areas. Most real estate markets, allof which operate in a uniquely local manner, were not affected bythe speculative bubble. Credit problems that came to light in 2007were of far greater concern to anyone needing a mortgage. But likeall markets, the cycle declined and then rose. The greed of tulipmania and the panic of the 2005–2007 real estate markets wereboth very irrational.The history of the stock market provides many examples wheregreed and fear also caused grief, and it all relates to perception versus reality of risk and how it works. At the turn of the twenty-ﬁrstcentury, the U.S. stock markets went through a speculative crazereﬂecting the modern era, speciﬁcally relating to the all-new Internet and its potential for vast future proﬁts. This infamous ‘‘dot.com bubble’’ will be remembered for many years to come.
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Modern Market Crazes: Greed and FearThe lessons of tulip mania are interesting, and without a doubt,those unfortunate speculators who lost entire fortunes were able tolook back and puzzle at how they lost perspective. But there aremany similarities between seventeenth-century Holland and twentyﬁrst-century America. Tulip mania was not an aberration, only anextreme example of the same tendencies that continue to this day.Between 1995 and 2000, a similar euphoria took over a largesegment of the U.S. market. This has been termed the ‘‘dot.combubble.’’ Relatively new stocks in the ‘‘Internet sector’’ grew rapidlyin value with individual investors buying up shares and large sumsof venture capital adding fuel to the ﬁre.One of the most puzzling aspects of the dot.com bubble wasthat many of the companies whose value soared in the periodseemed to exist only on paper and did not provide a speciﬁc productor service. Much as the mysterious but beautiful tulip bulb attractedspeculators 400 years before, the exciting and promising proﬁts ofdot.com had a similar effect. Even those dot.com companies thatdid have products often set up unrealistic business models. Andmany were formed by relatively young and inexperienced ﬁrst-timebusiness owners.At the time, the ability to set up an attractive Web page was morevaluable than understanding how to build and grow a business. Infact, rather than the traditional concept of offering excellent products at competitive prices, a new and different model dominated thedot.com industry: Sell at a loss to gain dominance in the industry,and support ever-higher losses with both equity and debt capitalization. The purpose was to crush competition and grow rapidly, withthe idea that proﬁts could be created later, when the dot.com‘‘owned’’ its market niche. On paper, it’s not a bad idea, assumingthat there is some point where the losses can, indeed, be turnedaround into proﬁts. Unfortunately, so many entrepreneurs acceptedthis model that any type of valuation became impossible in themarket.In hindsight, the dot.com craze was short-lived but shared manycharacteristics with the tulip craze of the 1600s, as well as specula-
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tion in railroads in the 1840s, and later, in the auto industry, transistor electronics, time-sharing computers, and biotechnology. Butlike all crazes, no matter the duration, dot.com came to an endrather suddenly. This is typical of how crazes go! First, they dominate and appear permanent. Then, quite suddenly, they disappear.At least when a bubble is based on a product like transistor radios or automobiles, there is a quantiﬁable factor identifying marketsaturation points. All markets are ﬁnite, so companies can sell onlyso many transistor radios. Even tulips exist only in a limited quantity, so there is some tangible justiﬁcation for value to change. Butthe dot.com bubble was different. There was so much competition,and so many identical business models ﬁghting for the same competitive market, that it became impossible for most of them to survive. Like all bubbles, a few early successes generated ever-greaterinterest. When people saw early speculators becoming millionairesovernight, more and more people wanted to get in as well. It isironic that the actual business model became secondary. Somecompanies might as well have been selling tulip bulbs online.Only in a bubble environment is it possible for a company tomake an initial public offering even though it has never reported aproﬁt, and has not been in business for very long—and be able tonot only raise money but also see its stock value soar. The growingvalue of dot.com stocks was most visible on the NASDAQ Composite Index, which peaked on March 10, 2000, at a level twice its sizeonly one year earlier. Such spectacular rises in markets is a warningsign, but typically, people invested in the dot.com industry refusedto consider the possibility that the good times would ever end.No single reason can be cited for the rapid demise of the dot.com business. Irrational panic over the widely hyped Y2K problems(which did not materialize), sell-off of stocks in many establishedcompanies like IBM and other technology-based growing concerns,and anticipation about the outcome of a big lawsuit against the leading software company (United States v. Microsoft) all added to thecrash of the dot.com business. But the primary reason was the lackof tangible value and the unrealistic price run-ups in precedingmonths. In three trading days ending March 15, 2000, theNASDAQ lost about 9 percent of its composite index value.
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Following closely on the dot.com craze was a period in whichmany big companies were reported to have accounting irregularities. Best known in this group was Enron, but many communicationsand IT companies had problems as well. WorldCom had exaggerated its proﬁts in the billions of dollars and ﬁled the largest bankruptcy in U.S. history. Other companies with problems includedGlobal Crossing (GLBC), JDS Uniphase (JDSU), and NorthPointCommunications (NPNTQ). While this was going on, dot.comproblems led to the dissolution of many companies, and charges ofwidespread fraud surfaced. Big Wall Street ﬁrms that had underwritten many of the initial offerings were ﬁned millions of dollars;these included Citigroup (C) and Merrill Lynch (MER), amongothers.Several years after the dot.com craze had quieted down, manymarket observers continued to be concerned. Rapid growth of companies like Google (with a P/E above 55 by October 2007) doubledits stock price in less than two years. Other high-P/E companies in2007 included Apple (AAPL) (48), Sun Microsystems (JAVA) (42),and Yahoo! (56). However, all of these are extremely overvalued,especially compared to competitors like Microsoft, with a P/E ofonly 24.Several years following the dot.com era, many of the survivorshave been buying up competition. For example, Google boughtYouTube and eBay (EBAY) bought Skype and PayPal. Other companies notable in the dot.com era included search engines (Altavista, Excite, Lycos); online brokerages (Ameritrade, E*TRADE);consumer products (Amazon.com, eToys, Pets.com, Priceline.com,Travelocity); and consumer services (GeoCities, InfoSpace, mortgage.com, Netscape, Telefonica).
Market RiskThe speciﬁc timing, length, and other features of bubbles in themarkets vary, but one thing remains the same: market risk. Thisrefers to the risk that your investment will fall as stock price de-
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clines. In extreme cases (like Enron or WorldCom), you could loseall or most of your investment capital. Market risk is impossible toavoid, but by remembering some of the fundamental guidelines andapplying analysis wisely, you can avoid unpleasant surprises.Rather than reacting with the two most common emotions inthe market (greed and fear), experienced investors follow a few sensible rules:1. Never follow the crowd, especially when emotions run high.As difﬁcult as this advice is to heed, it is essential to success in themarket. The overall tendency is to experience fear when prices fall,and to act impulsively by selling to cut losses and to buy, buy, buywhen prices are rising. These emotions—greed and fear—absolutely dominate the market, causing a lot of grief. Keeping acool head, taking a step back, and waiting before entering a tradeimpulsively is a wise move. If you have picked stocks wisely, employing tried-and-true indicators, there is no need to sell in a panic;in fact, a decline in price that seems extreme could present a buyingopportunity. Also resist the temptation to jump into speculative buying when prices rise quickly. The more they rise, the closer you areto the top, and the more likely a correction will occur.2. Be willing to lose a few golden opportunities in exchange forlong-term certainty. Without a doubt, you are going to experiencelosses; remember, it is easy to convince yourself that your entryprice is a starting point, when in reality it is only the current pricein an ever-changing series of price movements. Some losses are inevitable. By the same logic, you do not have to seize each and everyopportunity that comes along. If you try, it is virtually guaranteedthat you will suffer more losses rather than fewer losses. It is wiserto take some time and make decisions without the pressure of themoment. Apply your analysis to the long term, don’t buy unless thebasics make sense, and delay decisions until you are sure the decision of whether to buy or sell makes sense given the current priceand trend, and is based on thorough analysis.3. Set speciﬁc proﬁt and loss limit goals and follow your ownrules. The biggest mistake investors make regarding market risk is
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failing to set speciﬁc exit strategies for themselves, or to take stepsto protect their positions. As a consequence, they do not have anyidea about when to close positions. If a stock’s price is changingrapidly, stop loss orders (automatic orders based on the stockreaching a predetermined price) make sense. It creates an exit pointwithout requiring a separate decision. If you do not set an exit pricefor yourself, you won’t know when to take proﬁts or cut losses. Ifprices rise, the tendency is to hold off, hoping the prices will riseeven more. If prices fall, the tendency is to hold off hoping to getback to the starting point. In this almost universal scenario, whenand where do you exit?Market risk appears simple and easy to understand. But humannature is not. Market risk, which is dominated by human emotions,tends to become very complex. Investors have paper proﬁts anddelay making a decision, only to end up realizing losses becausethey end up making decisions at the worst possible times. The market is not going to conform to wishful thinking, and the reason mostinvestors lose money is simply because they react to signals in theway opposite of their best interests. It is irrational to buy at the topas well as to sell at the bottom, but that is how the course of eventsgoes too often.Market risk is not difﬁcult to understand, but acting at the righttime and making decisions contrary to the ‘‘group think’’ of themarket is the only way to reduce that risk. In respect of the emotional tendency of the market as a whole, market risk is the mostcomplex form of risk you face. But it is not the only risk; there ismore.
Inﬂation and Tax RiskPeople tend to underestimate the double effect of inﬂation andtaxes. Even when the current inﬂation rate is relatively low, it is easyto overlook. In fact, if you don’t think about inﬂation and taxestogether in the way that this ‘‘double whammy’’ impacts on yourproﬁtability, then you probably will not make a proﬁt in the market.
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An example: Let’s say you choose a stock yielding no dividendand invest $5,000 at $50 per share. You are conﬁdent that yourmoney will grow. Over the course of a year, the price of the stockrises to $53 per share. But did you really make a proﬁt? If we add acouple of modest assumptions about inﬂation and taxes, you mightdiscover that you are losing money. If the rate of inﬂation is 3 percent, you lose $150 in spending power of your $5,000 investment.Now if you apply the combined federal and state effective tax rate,you will need to reduce your proﬁts accordingly. For example, ifyou pay 33 percent federal and another 6 percent state income tax,your combined tax liability is 39 percent. If you were to sell andtake your $300 proﬁt, you would be penalized $117. The loss frominﬂation ($150) and taxes ($117) equals $267. So your true postinﬂation and post-tax gain over one year would be only $33, or 0.7percent. (This example does not assume a reduced rate for capitalgains and also makes no adjustment in the event you do not sell thestock.)In Chapter 1, you saw how a break-even rate of return appliedto investments, and Table 1-3 showed how some gross returns werereduced by inﬂation and taxes. Table 1-3 is duplicated here in Table6-1.The risk of inﬂation and taxes is considerable. Investors mayeasily delude themselves by thinking they are doing well by earning3 or 4 percent per year on their investments, but it is not alwaystrue. Even a 26 percent effective tax rate and 3 percent inﬂationyields a net loss at 4 percent.The terrible effect of inﬂation and taxes works to erode yourearnings. Because inﬂation occurs year after year and, just as inevitably, you have to pay taxes on your investment proﬁts, you actuallyneed to earn more than your assumed ‘‘good’’ proﬁt just to holdonto your spending power. This problem leads some investors tothe conclusion that they have to take greater market risks than theywant, just to offset the losses caused by inﬂation and taxes. This, ofcourse, has an undesired consequence. The higher the market riskyou take, the more exposure to loss. So even with inﬂation and taxesin play, greater market risk than your level of risk tolerance will notsolve the problem.
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TABLE 6-1. BREAK-EVEN RATES
EffectiveTax Rate
1%
2%
INFLATION RATE3%4%
5%
6%
14%16%18%20%22%
1.2%1.21.21.31.3
2.3%2.42.42.52.6
3.5%3.63.73.83.8
4.7%4.84.95.05.1
5.8%6.06.16.36.4
7.0%7.17.37.57.7
24%26%28%30%32%
1.3%1.41.41.41.5
2.6%2.72.82.92.9
3.9%4.14.24.34.4
5.3%5.45.65.75.9
6.6%6.86.97.17.4
7.9%8.18.38.68.8
34%36%38%40%42%
1.5%1.61.61.71.7
3.0%3.13.23.33.4
4.5%4.74.85.05.2
6.1%6.36.56.76.9
7.6%7.88.18.38.6
9.1%9.49.710.010.3
Other investors who consider themselves extremely conservative and risk-adverse choose ‘‘safe’’ but low-yielding investments.They may decide to invest their capital in insured certiﬁcates of deposit (CD) just to avoid market risk. For example, if your money isplaced in a CD for one year and it yields 3 percent, what is yourbreak-even point? If inﬂation is 3 percent and your effective tax rateis a very low 14 percent, you still need 3.5 percent just to breakeven. So the CD, in which you cannot withdraw money early without a prepayment penalty, is ‘‘safe’’ in the sense that its gross value(before inﬂation and taxes) cannot fall. But its true value will fall inmany cases because of inﬂation and taxes.There are some offsetting ways to reduce the effect of taxes,although inﬂation cannot be avoided. For example, if you set up aqualiﬁed retirement plan such as an IRA and invest through thataccount, taxes are not a consideration until you retire. In that case,you only need to beat inﬂation. So if you assume inﬂation is going
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to run at 3 percent, getting a 4 percent dividend on stock beats it,and a CD yielding 3 percent matches it with considerably low market risk.A second consideration is the application of favorable tax rates,for both capital gains and dividends. You do not always pay a fulleffective tax rate on every kind of income; the application of abreak-even rate should be tempered by actual rates as they apply,especially if a large share of your annual taxable income falls intothose categories. You do not always pay a full effective tax rate onevery kind of income; the application of a break-even rate should betempered by actual rates as they apply, especially if a large share ofyour annual taxable income falls into those categories.
Liquidity RiskYou want to have your money available in case you need it quickly.The stock market is highly liquid and you can sell today and getyour funds within three days. CDs are not liquid because early withdrawal causes penalties. Even less liquid than CDs is real estate. Youcan only get equity out of your house by selling, reﬁnancing, orthrough lines of credit and all of these may take time and involveconsiderable costs.It is not necessary to have all (or even most) of your portfolioin highly liquid accounts, for several reasons. First, you may haveadequate liquidity with relatively small percentages of your overallcapital. Second, the widespread use of credit cards lends a sort oftemporary liquidity to personal budgets. For example, if you needcash next week for an unexpected repair to your car, you do nothave to sell off stock. You can put the bill on a credit card and payit off in one month, or if you prefer, over several months. Usinglines of credit and credit cards is convenient and easy, and the onlydanger is becoming overextended. The point, though, is that traditional cautionary advice about liquidity is not always applicable. Afew decades ago, before credit cards were in such common use,ﬁnancial planners advised people to create emergency reservesequal to six months of income (more easily said than done) to en-
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sure liquidity. Today, you can achieve the same safety net with twoor three high-limit credit cards.A problem associated with liquidity risk also involves the state ofa secondary market. Past popularity of limited partnerships createdproblems because no secondary market existed; the only way to sellunits of limited partnerships was to take deep discounts. This isunsatisfactory, but today you can invest in real estate investmenttrusts (REITs) and accomplish the same market advantages as realestate limited partnerships. At the same time, REIT shares trade onpublic exchanges just like shares of stock, so past liquidity problemscan be eliminated altogether.In an ironic twist, it is the high degree of liquidity that so oftencauses problems for investors. The stock market is liquid, but madeeven more so by the ease of access with Internet-based discountbrokerages. The low cost of transacting business makes the marketeven more liquid, so today’s stock market is much more accessibleto the average investor than ever before. Only a few years ago, individuals preferred round-lot trading because the commission of oddlot trading was simply too high. Today, that problem has been eliminated because execution is so automatic that there is practically nopenalty for buying fewer than 100 shares. But in a way, this highliquidity can also cause problems. If it is too easy for people to makefrequent trades, it is also possible to make more mistakes, or tomake decisions at bad times. The low cost and ease of transactionpresents a new twist on ‘‘liquidity risk,’’ in which the higher liquidityitself creates a problem.Another aspect of liquidity risk relates to margin investing. It isfairly easy for most people to use margin to double up on their investment capital. But this creates a new variation on risk, that ofleverage risk. If you have $20,000 to invest but you are able to buyup to $40,000 in market value of stock, you could conceivably maketwice the money, but you could also lose twice as much. Using margin to invest is a higher risk because you have to pay interest to yourbrokerage ﬁrm for borrowing those funds. Many people who wouldnever consider borrowing money from a bank to invest in the market will go into margin without a second thought—even though itis the same thing.
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Nondiversiﬁcation and Overdiversiﬁcation RiskVirtually every investor has heard about diversiﬁcation; a detailedexplanation and analysis of this topic is found in the next chapter.But in terms of the risk involved, there is always the problem of toolittle or too much. Your portfolio has to be diversiﬁed enough toreduce market risk, but not so much that you create a no-gain situation. With too little diversiﬁcation, you are exposed to singular riskswith too much capital. With too much risk, your expectations haveto be lowered because exceptional gains will be offset by equallosses.A lack of diversiﬁcation is a problem, of course, and will be examined in greater detail in the next chapter. But what about theopposite problem, excessive diversiﬁcation? Liquidity, always thoughtof as a positive attribute, can work against you in the modern market. Equally serious is the potential problem caused by overdiversifying. It is ironic. In the past, virtually everyone was aware of theneed for diversiﬁcation; today, you can diversify so effectively thatyou create a low-yielding portfolio than cannot outpace inﬂationand taxes.In the modern environment of low-cost transactions and easeof accessibility to the stock market, diversiﬁcation may become excessive. If you diversify too much, then your overall investment islikely to be mediocre. Exceptional gains will be offset by losses, sothat overall you cannot outperform the market. This has been achronic problem with mutual funds that grow so large they cannotoffer exceptional yields. Even the relatively new exchange-tradedfunds (ETFs) are unlikely to outperform the market. By investingin a ‘‘basket of stocks’’ with similar attributes (same sector or samecountry, for example) you put your money into a broad range ofissues. You would probably do as well or better by buying the leading stock picked by the ETF. For example, why buy every pharmaceutical stock offered through a pharmaceutical ETF when youcould buy shares in the one or two companies with the strongestfundamentals?Another problem is that without the need to buy round lotstoday, you can easily buy only 5–10 shares in a broad range of com-
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panies. Many will do well, many others will not. This overdiversiﬁcation tends to have an offsetting effect, turning ‘‘excessiveeffectiveness’’ into ineffectiveness. Most proponents of the strategyknown as value investing believe that you only need to own three orfour stocks at the most, and that these should be the best-managed,bargain-priced companies you can ﬁnd. If you can put your capitalinto shares of three or four companies and perform better than themarket averages, it means you have just the right amount of diversiﬁcation.
Lost Opportunity RiskOne kind of risk often overlooked is that of lost opportunity. Thismeans that, if and when your capital is fully invested, you do nothave any money available to take advantage of opportunities whenthey arise. Capital is usually ﬁnite and as long as your capital isalready invested, the only ways you can seize new opportunities areto (1) sell something and move funds, or (2) borrow more money.Both of these alternatives are problematic because they may notserve your interests and may also bring additional risk into yourportfolio.Some investors unintentionally reduce their portfolios’ liquiditywhen they take proﬁts too early. For example, if you own shares offour companies and over time, two become proﬁtable, should yousell? If you do, then your portfolio ends up with only those stocksthat have either remained ﬂat or lost value. Over time, by sellingsuccessful stocks and keeping losers, you tie up all of your capitalin underperforming issues