FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 5.5: Defining Risk
There is an old expression on Wall Street that deserves some consideration: “There is no free lunch on Wall Street.” This means that you will never find a strategy that makes you lots of money while assuming no risk. The converse is also true: The more risk you take on, the more profit you should make. If want to enter into a financial contract with you and that contract crates risk for me, it seems only fair that you should reward me for that risk. This is a basic assumption of financial markets, and most financial transactions will take the level of risk into account.
Pretend for a second that you are a mortgage lender. You have to risk capital when you offer someone a home loan, but your losses are protected because the home stands as collateral for the transaction. If you require the borrower to “have some skin in the game” by requiring a hefty down payment, then you are not at all likely to lose money over the long haul, even if the borrower defaults on the loan. You will have to seize the house and then sell it to get your money back, and this takes time and money.
Since the time and expenses (lawyer fees, etc.) do create some risk for the lender, the lender deserves to be rewarded for taking on that risk. Risk-free loans are worth the current risk-free rate, which is usually determined by securities such as T-bills, which are backed by the full faith and credit of the United States government. If the mortgage company doesn’t get rewarded for taking risks, then they are better off putting that money in government bonds.
When money changes hands, it usually does so at some premium for the lender. Taking on no risk usually means that there isn’t enough reward in it for the lender to make a respectable profit. Government bonds currently fail to hedge inflation. At some future date when bonds are a relatively good investment and can help investors meet their investment goals, the price of other investment vehicles will decline. One reason the current Bull Market is so strong going into 2018 is that interest rates have been held low by the Fed for years, and the Fed promises only small, gradual moves upward in the near future. If that trend continues, the stock market can support today’s historically high valuations because there is nowhere else for investors to put money.
Now, pretend for a moment that you are a credit card company. Your borrowers have no collateral that guarantees that you will ever get your money back. You have to depend on the character of the borrower, and their ability to manage their budget in such a way that you always get your monthly share of the net. You can use credit reports to assess the risk, and you have the legal right to sue debtors that don’t pay their bills in civil court. Still, with no collateral to speak of, these are the riskiest loans in the world of legitimate business. You can charge a massive premium for taking on that risk. Most credit card companies do, and that is why I say that credit cards are evil and that you should never use them. When you take on risk to reap rewards, you are an investor or a gambler, depending on the depth of your analysis and your risk profile. When you willingly create a high risk for another person or company, you are poor. Plain and simple.
The Double-Edged Sword
Successful investing, then, often comes down to balancing risk with reward such that a consistent profit is realized. Investors that err on the side of caution are often referred to as risk-averse. A risk-averse investor will willingly choose a poor performing investment over a more profitable one that has a higher risk. If you are already very wealthy and are just trying to stay that way, then a risk-averse strategy can work well. University trust funds are a good example of risk-averse strategies that tend to do well. Billions of dollars can still make an impressive profit, even when invested in risk-free securities such as government bonds.
Risk aversion tends to be a psychological function that people develop based on their financial experiences over a lifetime. The most important period is childhood. I grew up listening to my grandmother’s stories of the Great Depression and was in constant amazement at her financial idiosyncrasies. She was mistrustful of banks and knowing that her bank was FDIC insured didn’t comfort her much. She always kept a cash reserve secreted away in her house, along with enough food to survive a zombie apocalypse. She never put a dime into the stock market and considered anyone who did a fool. If she knew how my retirement account is structured today, she would most likely thrash me for taking such wanton and foolish risks.
Those of us who grew up in better times where investments increased wealth feel very differently. My generation tends to be very materialistic and doesn’t save. Millennials tend to be investors, but prefer investments directly in companies that have a mission that aligns with their social and political agendas. Only a small percentage of this cohort has a pure profit motive when investing. Crowdfunding and other social capital experiments have proven attractive to millennials. A common idea is that small investments when combined with those of others can have huge social, political, and even environmental impacts. Many investors of the “greed is good” generation have lost their shirts betting against high tech companies that meet an environmental or social need that very young investors feel is important.
Note that I have described risk aversion as essentially a psychological process, which I believe it is. Very few investors seek to maximize the risk-reward ratio in any systematic, objective way. Part of this may be the federal agency that has as its goal scaring the average person out of investing entirely: The Financial Industry Regulatory Authority (FINRA). (I despise this heavy-handed surrogate mother that I never asked for, so take anything I say about them with a grain of salt). Here is what your mother (FINRA) has to say about investing and risk:
When it comes to risk, here’s a reality check: All investments carry some degree of risk. Stocks, bonds, mutual funds and exchange-traded funds can lose value, even all their value, if market conditions sour. Even conservative, insured investments, such as certificates of deposit (CDs) issued by a bank or credit union, come with inflation risk. They may not earn enough over time to keep pace with the increasing cost of living.
Regardless of what that statement implies, you can win, and you can win while taking on some risk. I do, however, like the FINRA definition of risk: “When you invest, you make choices about what to do with your financial assets. Risk is any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.” This doesn’t suggest that you go screaming for the hills and blocking your broker from calling your phone.
It does suggest that risk is real, and it must be understood and managed if you are to be a successful investor. What, after all, is the alternative? I submit for your consideration that depending on federal entitlement programs as your sole investment vehicle for retirement is extremely risky. The solvency of social security, for example, is a political football in every election that I can recall. A key element of any good investment strategy is diversification of assets. That is, “don’t put all of your eggs in one basket.” Social security is a single basket, one with lots of scrap iron rustling around in the bottom.
As I have argued elsewhere, your best defense against the future vicissitudes of social security is a well-funded retirement account that takes full advantage of tax breaks and employer matches. Beyond that, I fully support having an IRA that you control and that is geared toward maximizing your profits by taking on calculated risks. Most corporate and public retirement plans are so strapped with rules that you can’t do anything but make risk-averse investments. This isn’t such a bad thing given the sheer volume of cash that you’ll put in that account over a career and the magic of compounding over that very long time horizon. Most brokerage firms that manage such accounts make it very difficult and slow to move your money, and they have rule after rule to prevent you from trying to time the market. Other than a portfolio rebalancing once per year, your best strategy with this type of account is to buy the market and let it ride.
Types of Financial Risk
|Individual Security Risk (Business Risk)||This type of risk is defined by the fate of individual securities falling in value.|
|Market Risk||This type of risk is defined by the idea that all securities are to some degree correlated. When markets “crash,” all ships go down.|
|Liquidity Risk||This type of risk is defined by the idea that when things go bad for a particular instrument, you may have trouble selling it in the market and your losses can keep mounting until a buyer is found.|
|Geopolitical Risk||When world events stand to hurt the ability of an investment to reward investors per their expectations, they tend to sell the security and cause a price drop. Wars, embargos, regional tensions, and so forth fall into this category.|
|Concentration Risk||This type of risk is maximized when an all of an investor’s eggs are in one basket. If you own only tech stocks, a decline in that sector can be disastrous.|
Time, Risk, and Reward
FINRA has this to say about the topic of risk and time:
Based on historical data, holding a broad portfolio of stocks over an extended period of time (for instance a large-cap portfolio like the S&P 500 over a 20-year period) significantly reduces your chances of losing your principal. However, the historical data should not mislead investors into thinking that there is no risk in investing in stocks over a long period of time.
For example, suppose an investor invests $10,000 in a broadly diversified stock portfolio and 19 years later sees that portfolio grow to $20,000. The following year, the investor’s portfolio loses 20 percent of its value, or $4,000, during a market downturn. As a result, at the end of the 20-year period, the investor ends up with a $16,000 portfolio, rather than the $20,000 portfolio she held after 19 years. Money was made—but not as much as if shares were sold the previous year. That’s why stocks are always risky investments, even over the long-term. They don’t get safer the longer you hold them.
This is not a hypothetical risk. If you had planned to retire in the 2008 to 2009 timeframe—when stock prices dropped by 57 percent—and had the bulk of your retirement savings in stocks or stock mutual funds, you might have had to reconsider your retirement plan.
Investors should also consider how realistic it will be for them to ride out the ups and downs of the market over the long-term. Will you have to sell stocks during an economic downturn to fill the gap caused by a job loss? Will you sell investments to pay for medical care or a child’s college education? Predictable and unpredictable life events might make it difficult for some investors to stay invested in stocks over an extended period of time.
From the above statements, the magic of compounding that I’ve previously hailed as the greatest and most important investment secret of all time seems like a financial death sentence. First, no one (who is sensible) suggests that you dump ten grand into an index fund and let it ride for 20 years—as if a helping professional could afford that. Many financial experts warn investors t0 buy into a long-term position slowly, over time. Note that this is automatic with a scheduled contribution account like a 401(k) and with a constant dollar averaging strategy.
I cringe a little at the thought of an investor putting $10K into the S&P 500 at this moment. It has flown too high too fast and a correction is imminent. I make monthly contributions to such an account, but I’ve averaged into that position over 15 years and my overall cost basis is very good. If you must deploy a lump sum right now, you may consider putting it somewhere safe and liquid and deploy it only after a correction takes place. In the stock market, you can buy bond ETFs and gold ETFs that should provide such safe havens.
As much as I love the idea of being invested heavily in the stocks of great companies over a long time horizon, I understand the point FINRA made in the above quote. You don’t want to be 100% in equities as you near retirement age. When you want to start using that money rather than just helping it grow, you can’t afford big dips in the short term. That means as your retirement date approaches, you will want to move a bigger percentage of your investments into very low-risk instruments, such as bond funds.
How Many Eggs in that Basket?
As we move forward and talk about specific asset classes and the assets within those classes, we will consider various associated risks. For now, let’s consider two major principles of capital preservation that you will want to employ: Asset allocation and diversification.
Asset allocation refers to the idea that we don’t want all of our investments to be in the same board class of investments. By including different asset classes in your portfolio (for example stocks, bonds, real estate and cash), you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. Put another way, you’re reducing the risk of major losses that can result from over-emphasizing a single asset class, however resilient you might expect that class to be.
Diversification is used to refer to diversifying your holdings within a particular broad class of investments, such as stocks. Diversification, with its emphasis on variety, allows you to spread your assets around. In short, you don’t put all your investment eggs in one basket. Note that many stocks are highly correlated with other stocks. Correlated stocks tend to all go up and down together in a systematic way. All stocks are correlated to some degree, and swings in the overall market impact all stocks to some degree.
The overarching idea is to provide variance both within investment classes and between investment classes. Other than with massive economic downturns that impact all investment classes, these methods will help keep your portfolio in the green during short-term downturns in individual financial instruments.
Hedging is another important risk management strategy. Hedging is the buying of a security to offset a potential loss on another investment. The problem with hedging is that it adds substantially to the costs of your investment, which eats away any returns. In addition, hedging often involves speculative, higher risk activity such as short selling (buying or selling securities you do not own) or investing in illiquid securities. Some hedging strategies can be built into other strategies that are designed to make a profit while offering protection from a downturn at the same time. The best examples of these are options strategies, and we will discuss those in the final chapter.