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Rational Investing

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by Clark Davis

(This is the fifth in a series based on our most requested presentation, Rational Investing In Irrational Markets.)

After the interruption of our series for our State of the Markets column, we return with a discussion of risk. Interesting timing, since current stock market volatility is causing a lot of investors to reassess their risk tolerance.

Perhaps you have heard investors' comments such as, "If I ever get even I am getting out for good" or "I didn't think mutual funds would go down."

(Probably not, since most market participants love to talk about their winners, but seldom mention their losers. They may not be talking about losers, but trust me, many are thinking about them.)

For the past three years most market participants have not been interested in the cautionary sounds of those who have been through this before, preferring the siren call "double digit re-t-u-u-urns, double digit re-t-u-u-urns, buy on dips, dips, dips" of the "new paradigm" proponents.

Risk was not much of a consideration.

My, how quickly things have changed. A gentleman, who told us last year that he wanted to talk about using our portfolio management services "when the market isn't so high," yesterday said to me, "I don't want to do anything now. The market is down and I don't like the looks of it.

(Hmmm, don't most people prefer shopping when there's a sale?)

Risk to him, I learned after we discussed the subject for quite a while, is actually volatility.

He doesn't want to see the value of his investments go down ever! It may be that our service wouldn't be appropriate for him, since none of us here has the slightest idea of how to acquire investments that go up steadily from day one.

We know from experience that there is risk in any investment. As a matter of fact, we measure weekly the downside risk vs. upside return potential for more than 14,000 issues, and I have yet to see any issue that did not have some degree of risk.

Risk for this gentleman means that, regardless of long term appreciation potential, the price might, over the short term, dip below what he paid for it.

But there are other types of risks that should not be ignored.

Currency risk: In the past year international investing in individual issues or through mutual funds has demonstrated this kind of risk.

As the dollar strengthened against many foreign currencies, the value of investments denominated in those currencies fell.

Asia was a dramatic example, with many investments losing more than 70 percent!

Credit risk: As I have written before, there is only one investment that can be labeled "guaranteed" U.S. Treasury obligations. No other issuer has the unlimited taxing authority to guarantee payment of its obligations.

In all other issuance of debt, the creditworthiness of the issuer must be ascertained to determine the reliability of timely payment of interest and principal whether bank, insurance company, or bluest of blue-chip companies.

In a low-interest-rate environment, investors are sometimes tempted by ads or phone calls offering high-interest-rate issues. The rule of thumb to never forget is, the higher the rate, the greater the risk. Beware!

Inflation risk: The low inflation of the last several years has caused many people to ignore this risk. Retirees who lived through the double-digit inflation of the '70s and '80s recall that the inflation rate prior to that period was both low and steady.

They also learned that investments must provide a positive return after adjustment for taxes and inflation or at some point expenses exceed income. Then one of two things will happen lifestyles must change or principal must be invaded.

Do not be lulled by the current benign level of inflation no one was ever hit by a train he expected.

Our next column, "Selling Off to the Sleeping Point," will discuss how to determine your personal risk tolerance. In the meantime, I invite your questions and comments. Mail them to me at the SBJ or send them by e-mail to

ceo@slia.com.

(Clark Davis is a 30-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money management company. Questions or comments can be directed to him by mail via The Springfield Business Journal, 313 Park Central West, 65806 or by e-mail at sbj@sbj.net.)

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