This being my favorite board to follow, I found this post on RB and thought it worth while to post here.
"an education in risk tolerance"..
I brought this over from briefing.com. There is a lesson to be learned for certain, a very expensive lesson!
Updated: 01-Mar-05 13:13 ET
Investor Losses On Elan: Risk Tolerance Lesson
Yesterday's announcement by Biogen Idec (BIIB) and Elan (ELN) of the withdrawal of Tysabri, due to serious side effects of the multiple sclerosis treatment drug, including a fatality, sent the stock of Elan down by 65%. In yesterday's article, we analyzed how the risk side of both BIIB and ELN was visible prior to yesterday, by looking at the price/sales ratios. Today, we received an email from (or about) an investor who states he lost $360,000 on his Elan investment position yesterday and now faces a margin call of $112,000. It serves as a good example of the importance of knowing your own risk tolerance level.
Email Received
The email we received contained the following information:
Lost 360K and only had... 250K in equity. I know you will all say I was an idiot and I feel like one but I have been in and out of this stock for years and really felt I could appreciate the risk. I loaded up 20K share on margin only after the two approvals, the SEC resolution, and the Barron's endorsement of a double. Merrill forced me to liquidate today and I owe them 112K.
This has almost killed me emotionally, and while it is only money, I clearly lost more than I could afford or have ever imagined. Five years of trading profit gone in minutes this morning. I never should have margined; I should have diversified, and I should have my head examined for not seeing the signs that Elan refused to respond to all of the recent good news. There was something lurking and to see that this morning was more than devastating. I have no capital to re-build.
This was apparently posted in the Yahoo message board for Elan.
It was not actually clear whether this email was sent by the person who actually posted the message on the ELN board, or whether the email was simply copied by a reader and sent in. Our reply asking for details went unanswered.
Nevertheless, it has the "tone" of truth to it. There are certainly ELN investors whose losses yesterday were more than they could tolerate.
We publish this email today because it serves as a good example of how important "understanding your own risk tolerance" is to successful investing.
Understanding Risk
There are many types of risk that an investor must tolerate.
Actual loss of principal is just one of the risks investors must assume in order to capture the possible reward of an investment. It is however, what most people focus on. Focusing on "potential loss" is a better approach.
The following briefly summarizes some of other types of risk an investor must be comfortable with in order to succeed.
Potential loss: the possibility that an actual loss might occur (seeing this in Elan ahead of yesterday's collapse, was the topic of yesterday's article)
Volatility: wide swings in price that create paper losses while you hold your position
Opportunity risk: what you do not achieve in a particular investment because you choose an alternate investment (this is the risk most financial planners focus on, with respect to retirement planning. Inaction can be just as real a "loss" as actual principal loss.
While all possible risks are worth investigating, the risk of potential dramatic loss, as seen in ELN yesterday, should be a top priority. In fact, possible risk should be as deeply investigated as potential reward, before a position is opened.
Diversity Not The Answer
The usual response to stories such as the tremendous lose above, is that "investors should diversify."
But "diversity" is a very imprecise word.
To some it means "index funds," which in recent years have been a disappointment. To others it means "asset allocation," which means dividing your total assets between equities, bonds, and cash, in representative percentages.
There is actually nothing wrong, we feel, with concentrating your investment bets in just a few positions, even in very risky stocks, provided that your risk tolerance levels can accommodate the possibility of the risk scenario playing out.
To met that proviso, you must know your own risk tolerance level.
Learn Your Personal Risk Tolerance Level
The real lesson from the ELN investor's email is this: you must know your own risk tolerance level.
It is not enough to examine the risk inherent in any particular investment. You must deeply understand your own ability to tolerate that risk, if the risk scenario occurs.
It is very likely that if anyone had attempted to tell this particular ELN investor the extreme risk he had exposed himself too, he would have dismissed it. A strong faith in the company and the investment prospects often overrides an ability to see the latent risk levels.
Many investors admit to the risk levels inherent in their stocks, but dismiss the potential as an "unlikely" event. It is the nature of "high risk" scenarios to be "unlikely," usually, but the "unlikely" does occur.
But even if you do see latent risk, it is important to know will you be able to tolerate it, if that risk event occurs?
If you cannot answer that question for every investment position you have, you do not understand your own risk tolerance level. It is not a good situation to be in, as the ELN investor experience shows.
Hard Learned Lessons
During the immediate internet bubble-burst era, (from April 2000 through summer 2001) emails such as the one we received today were commonplace. Our file containing the collection of sad tales and hard learned lessons has literally thousands of pages in it.
At the time, we felt that investors had learned the lesson of excessive exposure and highly valued stocks. In fact, it seemed as if the market had drilled caution into the hearts of individual investors so deeply that the types of extreme losses seen in the bubble-burst era would become rare events.
In fact, we also thought it likely that extreme overvaluation of stocks, based on speculative premises, would also become rare.
To some extent, those expectations have come true. In May of 2000, after Red Hat (RHAT) had collapsed 85%, we stated "You will probably never see a profitable business with a price/sales ratio of 1,100 ever again."
For the most part, that has been true, but price/sales ratios in double digits are still good indicators of implied risk. ELN's price/sales ratio, for example, was 22 last week, and is just 7 today.
An investor who understood that ELN might fall from p/s ratio levels of 22 to today's levels, which are still higher than most drug stocks, certainly didn't enjoy the collapse yesterday. But they tolerated it as part of the rules of the game. Sometimes you lose.
Conclusions
Apparently, the lessons of risk are still being learned - the hard way - by many investors. Hope springs eternal.
The lesson here is that careful attention to "risk tolerance" is essential to making your reward dreams. It is at least equally important as analyzing the potential reward. For some, like the ELN investor described in the above email, it is even more important.
If you have not taken the time to analyze just how risky any of your investments might be, now is a good time.
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