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Five Risks We Wouldn't Take

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to the Friday Five. We are wrapping up Risk Control Week. And one of the points we have this week is not that you shouldn't take on any risk. In fact, if you want to get some kind of return, you almost have to take on some amount of risk, but there are, that said, some risks that we just wouldn't take.

Here with me to talk about that is Morningstar markets editor, Jeremy Glaser. Jeremy, thanks for joining me.

Jeremy Glaser: You are welcome, Jason.

Stipp: What do you have for the Friday Five this week?

Glaser: Well, this week we're going to see that you shouldn't just take risk because you think you're going to get get reward without checking it out.

That you need to be focused on what's going to happen on taxes.

We don't want to take the risk of thinking that margins are going to continue to expand at the same level that they've been doing.

We're not going to take the risk of overstressing out about volatility.

And finally we're not going to take the risk of being too trusting.

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Stipp: So, for the first one, this risk-reward; I think this is important concept, and the amount of risk that you are taking on for the amount of reward that you are getting. What do you think is a risk in that sense that you wouldn't take?

Glaser: Well, certainly most investors think, Oh! Well, if I take on more risk, I must be getting more reward for it, because that's kind of a fundamental axiom of modern investing. But the truth is that you have to actually make sure you are getting paid for that risk.

I think there is plenty of stocks out there right now, where you can take on a ton of extra risks that have a lot of uncertainties surrounding what could happen with it, but the potential returns aren't that great. When you are looking for a risk-reward or a trade-off, you want to find one where the upside is many times the downside, and that's the kind of bet that you want to be making.

Stipp: So, you have to make sure you are getting paid, but also understand that you might not get paid at all if something really bad happens?

Glaser: Exactly.

Stipp: So for the second point taxes, there is some tax uncertainty on the horizon; it would be a risk to ignore that?

Glaser: There is certainly always uncertainty when it comes to taxation, but right now we have a particularly acute sense that we don't know what's going to happen, because the dividend tax cuts that were passed during the Bush years are set to expire at the end of this year. What exactly Congress is going to do to fix this? Nobody knows yet.

Right now, dividends and the capital gains taxes are at the same rate, which we think is a really good idea, because it incentivizes companies to actually pay out money to shareholders instead of just saying, "Oh! It's better for them to cut the capital gains for tax reasons."

So I think investors should be tuned in to see exactly what's going to happen out there, what's going to happen with other tax rates. They shouldn't unnecessarily stress out about it, but definitely something they need to think about and something that's going to impact your portfolio for years to come.

Stipp: Another mistake that a lot of investors make is they'll look in the past and then they'll just assume that trends that they have been seeing will continue on in the future forever. That's a risk?

Glaser: Absolutely. And you see that with margins. So we have had margin expansion look really good over the last couple of quarters. Companies have really cut to the bone. They've taken any expense that they thought was expendable and gotten rid of it. And now as revenue is starting to come back, you are seeing that operating leverage, or taking those operating costs out, has been really positive for them and margins are getting better and better, but this can't happen forever.

There is only so much you can cut, before you have to start investing to make the business grow again. So, as the economy continues to recover, we're going to see companies invest more, and profitability is not going to look as good as it did in the past.

Stipp: Another issue that a lot of investors have been dealing with over the last few months is all of the volatility, but there is some risk in thinking about that volatility the wrong way.

Glaser: Volatility, in and of, itself is not a huge problem if you are a long-term investor. If you don't need your money for 20 or 30 years, you are not really that concerned about, if the stock goes up or down 5% or 10% on any given day.

Now, if you need that money in the short-term, you are obviously worried, and maybe stocks aren't the place you want to be, but I don't think you should be terribly focused on the volatility as the biggest risk factor in the stock, and worry more about some of the uncertainties and some of the business risks that could be there.

So you need to be more concerned about, is this product going to be successful over time? Will they be able to build value? Can they have long-term competitive advantages? Those are the kind of questions and those are the kind of risks that I think investors should be focused on more than short-term volatility.

Stipp: Because, naturally there is going to be some volatility in there, and the fundamentals aren't always going to be driving that in the short term.

Glaser: Absolutely.

Stipp: So for the last point, Jeremy, I think that the last few years have really shown us that it's really important to do your own critical thinking and not just blindly trust one rating or something like that?

Glaser: Exactly, the rating agencies, I think, are a prime example of this. And we saw it this week, when the rating agencies – and now brace yourself Jason – downgraded Greek debt to junk status. Now, I know this comes as a complete shock. No one had any idea that Greece was having any problems, or wait maybe it's been in the news for the last couple of months, and there shouldn't be all that surprising to people.

But certainly, it shows that when you are looking at information, and people are giving you information, it's really important to think about it critically. And if when the rating agencies were saying that Greece is still potentially a good buy or it is potentially still investment grade, investors should have been able to see thorough that and should have been able to look forward, and not just look backward.

It is important when you are evaluating information, to really think about it, and make sure that it's forward-looking and has taken into account all the information and isn't just anchored in the past.

Stipp: Jeremy, thanks so much for joining me.

Glaser: You are very welcome.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.