Avoiding financial heart attacks

'The risks that scare people and the risks that kill people are very different', reads a line from Freakonomics by Steven D. Levitt and Stephen J. Dubner. It highlights the fact that our fears are often irrational. We tend to worry too much about things that are out of our control and not enough about more dangerous risks that are within our control.

For example, many people worry more about flying than driving (even though the risk involved in flying is similar to or less than that of driving, depending upon how it is measured). Others worry more about being the victim of a terrorist attack than a heart attack, even though the latter is a far more likely event.

Canned food stockpile 

Things are no different in the investing world. For example, about 12 months ago I spoke with a reader who was still working her way through the canned food she had stockpiled during the 2005 bird flu scare. Terrified that the pandemic might reach her home town and render the population house-ridden, she'd purchased a mountain of canned goods to see her through the impending turmoil.

It's a wry, instructive story. Less than 30 months ago many stockmarket investors were spellbound by the idea of a bird flu pandemic. In fact your analysts were busily fielding correspondence from members who were worried about how bird flu might impact their portfolios. The same goes for SARS in 2003 and, before that, the threat of terrorism. This illustrates a key point: we're especially susceptible to vivid events and the risks that they pose, but frequently neglect the impact of less dramatic events that may be more threatening.

Shockingly vivid

After the shockingly vivid terrorist attacks of 11 September 2001, many people were fretting about which Australian stocks might be vulnerable to any domestic terrorist threat. Before that there was the dreaded 'Y2K bug' and mad-cow disease. The current 'credit crisis' is simply the latest attention-grabber.

Now, the credit crisis is real and we're certainly not advocating that you ignore its effects and potential impacts. What we are saying is that it's crucial not to focus on the latest scare making headlines to the exclusion of all else.

The threat of terrorism, for example, is as real today as it was on 12 September 2001 but few people are currently focusing on it. Why? Because there hasn't been anything quite so dramatic as the initial attack more than six years ago and nothing at all on home soil. The perceived threat is receding whilst the real threat is the same as it ever was. The same goes for a litany of other risks.

Our fearful reader, surrounded by tinned beans and corn, should be just as afraid of bird flu as she ever was. With global travel more widespread than ever, the risk has only increased. But as investors and naturally greedy (or 'aspirational') human beings, we have a problem.

One of our favourite quotes sums it up nicely: 'When it doesn't rain I have no need to fix the hole in my roof and when it rains I can't go outside to fix it.' It's easy to ignore a risk that hasn't recently reared its head. After it does, we lament the fact that we didn't see it coming. Academics refer to this as 'recency bias'.

Perfect predictions

Our society also seems to be increasingly fixated on predictions. 'Experts' are asked questions like: Where will the All Ordinaries index be at 31 December 2008? Or where will the Aussie dollar be at the end of the financial year? Some organisations even publish forecasts for the coming year (with a straight face). Few bother to assess their record of past predictions.

Predictions have a veneer of certainty but, like a puff of smoke, are quickly forgotten. They are meant to offer reassurance but have the effect of causing many an investor to worry about the wrong things or, worse still, not worry at all.

Better to be prepared for a broad range of eventualities than gamble on a narrow prediction playing out, we say. And better to focus on the less vivid but more likely risk factors that you're exposed to—the financial equivalents of heart disease.

Top of the list is overpaying for stocks. At best, overpaying for good businesses can lead to years of sub-standard returns (those who paid $28 per share for Flight Centre in March 2001 have achieved an annual return of 2% over almost seven years). At worst, overpaying for fragile businesses can lead to disaster, as it did for owners of Centro Properties Group.

Improve your chances

The good news is that the price you pay for a stock is completely within your control. Paying an appropriate price for stocks (which we define as leaving a margin of safety between the price you pay and your estimate of value) is like eating a low-fat, low-sugar diet. It won't provide 100% protection against a bad outcome but it will significantly improve your odds of survival.

It can also be anything but fun. Like eating a healthy fruit salad while those around you gorge on Christmas pudding, buying only sensibly-priced stocks in a raging bull market can make you feel like an outsider. But it will make you a better, more successful investor.

Sticking to the stocks that you really understand is also a good idea. It's crucial to comprehend how a business makes money and what the various risk factors are. Our task as investors is not to avoid risk—that's impossible—but to ensure that we're adequately compensated for the chance that today's investment develops into tomorrow's disaster. If we do this often enough, by diversifying and identifying new opportunities as they arise, we're bound to prosper over the years. The best thing to do is to worry about the most important risk factors, especially those within your control.