In this post, “The Risks You
Take,” I have chosen to follow up my previous piece “Fearing Greed” with a
rewrite of a piece I wrote many years ago on risk. In addition, I will post a more elaborate
blog piece on risk, tentatively titled “Risk, Uncertainty and the Unknowable”
this summer. I believe that now, the
year 2014, is a good time to reassess your investment goals and risk profile
given your age, health, job prospects and wealth. We are five years older than we
were when the U.S. equity market bottomed in the spring of 2009. If you are an
individual investor, you are that much closer to retirement; you may be in or
past your peak earning years. If you are
an institutional investor, it is likely that your investment committee has completely
or largely turned over and that the new members have only a vague understanding
of your investment policies and process during the period from 1998 to
2009. You are at great risk of repeating
your previous mistakes unless you have a documented history of your past
process and results. A complete review
of your Investment Policy Statement is also in order.
We are now in the fifth year
of a bull market for U.S. equities. The
world is awash with liquidity; interest rates remain near zero on short-term
credit instruments. As a result, investors are losing money at a rate greater
than 2% per year after taxes and inflation.
Despite, or perhaps because of it, the productive assets of much of the
world, be they human capital or factories, remain in surplus and either
unemployed or underemployed. This long
period of price fixing interest rates, sometimes referred to as “ZIRP” or Zero
Interest Rate Policy is, I believe, most likely doing irreparable harm to the
world. Low interest rates encourage
consumption while discouraging saving and lure some investors into more risky
assets in their search for yield. Thus,
current consumption is higher than it should be and will result in the
misallocation of human and financial capital.
This will only make the next recession more severe. Finally, the world is coming closer to
currency wars with the danger of competitive devaluations and risking political
reaction in the form of trade restriction and potential capital controls.
Get your financial house in
order.
THE RISKS YOU
TAKE
RISK, UNCERTAINTY AND ACTS OF GOD
All investments involve some form of risk and
require you to make a trade-off between the type and amount of risk you are
willing to assume and the potential return you could receive. To realize a
return on your investment, you must take some risk. Investment theory assumes that
the higher the potential return, the greater the risk inherent in the
investment. Unfortunately, while one might expect that risk can be avoided by
refraining from investing, it doesn’t work that way. At the other end of the
spectrum, we find that by avoiding the financial markets and keeping their
retirement savings under the mattress, investors do not eliminate risk; they
expose themselves to a different set of risks. In fact, one of the riskiest
things you can do is to not invest your money at all. This “non decision” is in fact a
decision. When you choose not to invest, you expose your
money to purchasing power risk and eliminate the potential for growth of
principal. The safest strategy for long-term investing is a well-diversified
global portfolio that addresses your needs, goals and risk tolerance and that
strikes an efficient balance between risk and return. However, building this
portfolio is easier said than done. You must consider risk, uncertainty, and
acts of God as you select your holdings.
Risk, in the statistical sense, refers to a
known distribution of events and the chance that you may receive a lower return
than you expected. For example, suppose you flip a fair coin ten times. It is
quite plausible that you could have seven heads or tails when you expect five of
each. If you flip the same coin 10,000 times your results will come much closer
to fifty percent heads and fifty percent tails; flip 100,000 times and the
results will be even closer to fifty percent heads and tails. This tendency to
get closer to the expected result when you have a bigger sample is the law of
large numbers. This law applies to many games of chance when you have
independent (i.e. the result of the next coin flip does not depend on the
previous coin flip) events.
Alas, while we are able to calculate
historical distributions of many financial variables, it is not at all obvious that
these distributions are stable enough to give us anything more than a rough
estimate of risk. Thus when we talk of “financial risk,” it is not with the same
precision as coin flipping and the law of large numbers. Nevertheless, by
looking at the history of financial variables, we are able to quantify risk as
it occurred in the past. Great care must be taken, however, not to predict the
future based on the statistical history of such variables. It is best to treat
the past data as only suggestive of the range of possibilities that might occur
in the future.
The fact is, the future is unknowable. We
refer to this unknowable future as immeasurable risk or “uncertainty.” Uncertainties,
along with acts of God, are two of the most significant uncontrollable
destroyers of wealth. “Acts of God” are frequently referred to in a financial
crisis, but while acts of God often have devastating financial impacts, the
term itself is actually a legal term that refers to events that are not the
result of human action nor subject to their control. Tornados, hurricanes, and
floods, for example, are acts of God. Fraud, war and divorce, being the result
of human action, are uncertainties, rather than acts of God, even though they may
have a profound effect on your wealth. When compared with uncertainty, acts of
God are different in one very important way: in the modern financial world it
is possible to purchase insurance to protect a portion of your assets against
the damage resulting from these events.
When you, as an investor, have accumulated a
surplus of cash, you have an investment dilemma and are exposing yourself to
risk. Cash, not invested in some form of earning asset, assumes the risk that
when you wish to spend that cash in the future it will purchase fewer goods
than it does today. To benefit from saving money, you must mitigate this
purchasing power risk. Indeed, saving money is the process of giving up the
pleasure of spending today in anticipation of spending it in the future. If the
money buys fewer goods at that future date when you are ready to spend it, you
have delayed that pleasure for no purpose. However, the moment you purchase an
earning asset with your surplus cash, you engage in a series of investment-related
risks. The first risk you face is being defrauded. This risk can be greatly
reduced by carefully following our “Rules of the Road for Staying Rich.”
General
Disclaimer:
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solicitation to sell or an offer, recommendation or solicitation to buy or
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solicitation may only be made by means of an investment management agreement,
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investment, tax or legal advice.
Labels: Opinion