Tuesday, April 10, 2012

How to eliminate risk (part 1)


Welcome again! This week I thought I’d focus on risk management, which is often perceived as being particularly boring (because it often is), but can actually be interesting – or at least informative and useful! (I’ll try not to keep it too dull).

Whilst there are many different ways of reducing or eliminating risk, for many different types of financial assets and situations, I’m going to focus on one which will be relevant to many people – anyone who has ever owned shares directly, or indeed anyone considering it.

Most people have health insurance (hopefully), to avoid the risky situation of needing medical treatment but being unable to afford it. Many people will insure their car, to avoid needing to buy a new one every time a half-asleep bus driver crashes into it. A lot of people will even insure something as cheap as a mobile phone, simply because for a relatively small sum of money, they can be sure that when they lose it (again) it’ll be replaced by a shiny new one.

But how often do you hear of people insuring their investments? Whilst there are some financial products which offer capital guarantees, or guaranteed returns, for something as simple as owning shares in the company you work for many people simply don’t realise that it’s possible.

In fact, it is possible – most of the time.

Technically, it’s known as a “protective put” strategy – which can seem somewhat daunting, if you’re not familiar with financial terminology – particularly in a world where complex financial instruments have been blamed for many facets of the global financial crisis. But in reality, it’s relatively simple – and I’ll explain it now.

Essentially, “protective puts” allow investors to lock in a guaranteed sale price on their shares over a predetermined period of time – it basically gives you the right, but not the obligation, to sell those shares at that fixed price - for a relatively small cost. (I’ll come back to the cost later).

And this strategy works in two main situations – either when you’re buying shares, or when shares you already own have risen in value and you want to lock in those profits.

If, for example, you wanted to buy shares in a certain company which were currently trading at $10 per share, you could simultaneously buy “protective puts” for the same number of shares, at the same value, valid for the next year. This means that the worst case scenario, the most you stand to lose, is the cost of buying those “protective puts” – the cost of the insurance. And you still stand to benefit from any rise in the share price, and any dividends received (less the cost of the insurance).

In another example, you may have bought shares in a company for $5 per share which are now valued at $10 per share – or maybe they are shares in the company you work for which were given to you at a big discount – and you want to lock in your profits. You basically do the same thing as in the example above, and you now know that you will be able to sell those shares at their current value, even if markets fall.

So, how much does this strategy cost? Well, as a general rule, this cost is usually in the region of 8%.

Note that I said “relatively” small cost earlier – 8% may seem huge to some people, and insignificant to others. It all depends on your point of view.

If you are a small investor, with a few thousand dollars’ worth of shares in your favourite big company, 8% might be your expected earnings for the year – and therefore paying 8% to insure it may seem completely pointless.

However, the main purpose of this strategy is to eliminate huge downside risk – the risk of losing most of your investment. And in volatile markets, when you’ve got a sizeable portion of your wealth invested in to just one company, that type of situation could be disastrous.

And whilst these situations tend to be relatively infrequent, they do happen – they’ve even happened to me.

I spent most of the last decade working for Lloyds TSB, the largest retail bank by market share in the UK. And during this time, I accumulated a significant number of shares in the company, as a combination of save-as-you-earn schemes, partnership shares, free share awards, and bonuses. Most of these were bought/earned/awarded at a significant discount to market price – on average, vastly more than an 8% discount.

At their peak, they were trading at well over 600p per share.

Around the start of the global financial crisis, in the space of just a few months, they dropped to around 60p. They lost 90% of their value, and cost me tens of thousands of pounds in the process. Did I have them insured? No. Did I feel stupid? Yes. Will I ever take that risk again? Certainly not. And by the way, they’re now trading at around 30p each.

Again, whilst big falls like this are rare, they DO happen – remember the oil spill in the Gulf of Mexico? The share price of BP fell about 55% in a matter of days, and even now they’re worth about 30% less than they were a couple of years ago.

So for all you boys and girls working for the big oil/gas/mining companies over here who benefit from great company share schemes – I know Schlumberger have a very generous one – do you want to take the risk that someone you’ve never met may forget to do a bolt up properly and cost you tens of thousands of dollars? I wouldn’t if I were you.

Obviously it’s not just the oil/gas/mining companies that are at risk from “low probability, high impact” events – unforeseen occurrences befall us all.

So if you have a significant amount invested into shares, please consider protecting yourself. And particularly if you get shares from your employer at a discount – technically it won’t even cost you anything to put in place.

To find out more about this, and to look at your options regarding shares you currently own or are thinking of buying, send me an email to arrange a time to talk – my team and I are very happy to help.

Have a great week!

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