CNNMoney recently featured an article headlined “Risk is back”. Was it ever gone?

In 2005, Allan Greenspan gave a speech in which he expressed concern that investors were becoming cavalier about accepting lower risk premiums and therefore paying for overpriced assets. (“Cavalier” is my paraphrasing. He’d never use a word so dramatic as that.) Greenspan continued, “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

In finance, risk premium usually refers to the amount (%) over the risk-free rate that investors expect to gain for taking on an investment involving greater risk, such as stocks. The risk-free rate itself is a theoretical construct (nothing is actually entirely risk-free), but in practice, the interest rate on a short-term US Treasury bill is usually used. Both risk-premium and the risk-free rate come into play in the ubiquitous capital asset pricing model (CAPM), which describes the relationship between risk and returns.

Let’s see: the current rate on the 3-month T-bill is 4.8% (as of June 14, 2006). How much do you expect your investments in the stock market to return? Any ideas? How about examining historical returns? Here’s a lovely page from Stern that’s updated regularly showing historical returns on T-bills, stocks, and bonds.

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During these days of market volatility, it’s worth reminding ourselves of why we invest. If you’re a true investor and have done your homework, then the following parable from Chapter 8 of the The Intelligent Investor will help you keep some perspective (emphasis mine):

Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

I was really struck by this metaphor when I first read it. If I were a business owner, would I let someone from the outside tell me how much my company was worth? Who better to determine the value of my business than myself? In value investing, presumably, if you’ve done your homework, you’ve invested in a company’s stock because you believe the company is worth putting you money into, and not because it’s a way to win big fast, like playing roulette or Deal or No Deal. If so, then your ability to resist what others think your shares are worth should be easier to do.

For some reason, I always picture Mr. Market as Wormtail from the Harry Potter series. O0bsequious, and easily abashed and led toward adulation or despair. I don’t know why.

For completion, I’m including the critieria that Benjamin Graham listed for finding value investments for the “enterprising investor”.

Graham divided investing into what he categorized as “defensive” or “enterprising (or aggressive)”. In essence, a defensive investor is one who’s interested mainly in passive investment, such as someone who regularly dollar-cost averages into index funds. Graham devotes several chapters and paragraphs to what an enterprising investor is not, but essentially, we can sum up this sort as someone who seeks a greater return than a defensive investor, and is willing to put in the time and effort to find appropriate opportunities for both nearer and longer term. I put an emphasis on appropriate because there are many people out there who would consider themselves “aggressive” investors but would still not fit the definition here.

For enterprising investors, Graham loosened some of his criteria. I’ve listed them below. However, I have no doubt that they are probably out of date given the changes to business and industry since the last revision of his book was written in 1972. Worth reading are the comments made by Market Participant on the post I wrote on criteria for defensive value investments. He shares some insightful advice and rightly points out that calculating numbers in a 10-K is not the same thing as gaining real insight and knowledge into a stock and illustrates why some of these ratios may be out of date.

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Many people who invested in the late ’90s incurred capital loss carryovers that can be used against future capital gains and deducted from taxes in future years. Being one of these people, I was curious as to whether there were any ways to maximize the use of these carryovers. I’ve been thinking of these carryovers as a personal, rather than a corporate, deferred tax asset, though that may not be strictly correct. Short-term capital losses can only be netted against short-term gains, and long-term losses against long-term gains. In my case, I have more of the latter than the former.

Since I’ve started investing seriously and decided to focus on long-term results, I’m considering doing the following:

1. Purchasing shares of an ETF or index fund, and holding them for at least 12 months so I can net long-term gains against the long-term loss carryovers.
2. Once the 12 months or more are up and I’m able to realize a gain, selling part of those shares to net against my long-term capital loss carryovers.
3. Then, rebuying those previously sold shares later when the price has fallen a bit. In this way, I could realize the gain without incurring taxes, and possibly also take advantage of a price drop as well.
4. Repeat the process, until capital loss carryovers have been used up

The problem I see with this is that it’s always easier said than done. When the time comes to sell, will I actually be able to do it, or be paralyzed in the moment that it’s the wrong time to sell? And of course, there’s never any guarantee that once you sell, there will be a price drop and an opportunity to re-buy.

I also haven’t given much thought as to whether it’s better to use up all my carryovers as soon as possible (due to the time value of money), or reserving some for later in case my tax bracket changes later in life, since, unless the current law changes, capital losses can be carried over for use indefinitely until they’re used up.

So, anyone else have any good strateges or recommendations for maximizing capital loss carryovers?

The poll I ran a while ago on 10-Ks didn’t get many takers, but I decided this might be a useful enough topic to write about anyway. It turns out, I think, that unless they’ve had a business school education or worked in finance, most people find 10-Ks intimidating, boring, and unappealingly long documents. That might seem to be the case, but they’re chock full of information on a company and well worth reading before choosing to invest money in the company’s stock. Even if you don’t know what all of the terminology means, or how to calculate financial ratios, you can get a good idea of what the company does, what risks there might be to its operations, and what plans management have in mind.

What are 10-Ks?
10-Ks are documents that the SEC requires that each and every publicly-traded company file at the end of their fiscal year. They’re also sometimes called annual reports, though I tend to think of these as the nice fancy books that come with the 10-Ks that the company mails out each year that do more highlighting and marketing of the company than anything else. Companies are required to mail you these documents (physically or, sometimes, electronically) if you own even one share of their stock, but if you’re looking at potential companies to invest in, you’ll find these easily accessible at either EDGAR or the company’s own website. Yahoo! Financials also links to a company’s most recent SEC filings, and their interface is a little easier to use and read.

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