A few thoughts on investment risk
Whenever you invest the outcome is uncertain.
Even when you deposit money with a bank the money isn’t entirely safe due to the banks operating an incredibly unstable business model. People think that deposits are safe for two reasons.
1.Banks don’t tend to get into major problems too often.
2.The government provides a level of protection for the savings deposited with a bank.
If truth were told however, depositors can deposit money with a bank that do things correctly, but still end up losing out through inflation.
Sometimes, extreme inflation can make your savings worthless.
People who warn about high levels of inflation, are largely disregarded by the media as ‘doomsayers’, but the fact is that if you view the world’s financial history, it is filled with stories of financial disaster and high inflation.
There seems to be at least one country in the world experiencing this level of monetary upheaval at any point in time.
If you wish to maintain and enhance your savings, you have to do a little more than leave your money with your local bank.
This brings with it greater levels of uncertainty and the possibility that you will suffer losses, rather than benefit from gains, and may even lose your shirt.
In order to explain the risks of investing to every day investors in a simple way, and not scare them off by spending too much time discussing the risks of loss, the financial services industry has jumped onto the use of a single factor, volatility, as the primary or sole explanation of investment risk.
I have many reservations with this approach, more of which will be outlined in my forthcoming e-book Don’t Lose Your Shirt, but the main one is that volatility is only one type of risk you face when investing. It should not be your sole focus as there are many more important risks to be aware of.
Can using volatility as a measure of risk cause you to lose money?
James Montier, an investor with Global Investment Management Firm GMO LLC, explains the issue of volatility in a 2010 GMO White Paper.
However, risk isn’t a number. It is a concept.
Ben Graham argued that we should focus on the danger of permanent loss of capital as a sensible measure of risk: What is the chance that I will see my capital permanently impaired by this investment?
This strikes me as a much more sensible viewpoint than the mathematically elegant but ultimately distracting practice of assuming that risk is equivalent to standard deviation.
Volatility creates opportunity, not risk.
As John Maynard Keynes long ago opined, “It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”
The importance of price
The use of volatility has lead to lower volatile asset classes being regarded as low risk and higher volatile asset classes being regarded as high risk.
In general, I understand the logic to this approach, but it doesn’t necessarily always lead to the correct decisions being made.
Are you risking your capital to a greater extent purchasing a single company stock when prices are low, or investing into government bonds when market prices are high?
Put more simply, are you at greater risk of loss when prices are high or when prices are low?
When prices are high, the period before it tends to have low volatility. Yet when prices are low, the period before it tends to have high volatility.
Issues with Data
Anyone who is an investor uses the vast amount of data at their disposal to attempt to form sound judgments and make sensible allocations of their own, or their client’s capital.
Unfortunately, a disproportionate amount of financial research, theories and investing ideas have been developed over the last 30-40 years, with the vast majority of it using data from the same period.
Looking at this scientifically, this is a very short period of time to be able to rely on the data inputs.
Limited data should only offer limited conclusions, but I feel the theories and investment models developed from this data are widespread and some are viewed a little too dogmatic.
Since the mid-eighties, financial markets have been hugely influenced by a very long-term bull market in government bonds, the gradual reduction in many central banks interest rates to what are presently historical lows, expansion in many types of debt, and then further manipulated by the injection of money into the global financial system by large amounts of QE.
We have to consider the possibility that these data inputs are invalid as they reflect a distorted period for financial markets and thus any investment theories, models and conclusions we draw from this data may be invalid.
Why don’t investment professionals spot risk very well?
Retail investors pay financial professionals very handsomely to manage their money, yet so many of these professionals are frequently taken surprise when the risk of loss becomes reality of loss.
Most of them are deeply aware of the risks inherent within financial markets, so you would be forgiven for being a little confused why they’re aren’t better at spotting them buildup before it’s too late.
I think this flaw in our ability can be largely explained by our human behaviour.
Charlie Munger gave an excellent speech in June 1995 at Harvard University on the Psychology of Human Misjudgment.
For those interested in understanding human behaviour and not solely from an investment perspective, I highly recommend reading the full transcript.
“If you throw a frog into very hot water, the frog will jump out, but if you put the frog in room temperature water and just slowly heat the water up, the frog will die there.”
“If it comes to you in small pieces, you’re likely to miss, so if you’re going to be a person of good judgment, you have to do something about this warp in your head where it’s so misled by mere contrast.”
Ultimately risk comes from not knowing what the future has in store for us.
Finally, it is worth bearing in mind that in spite of many mathematical attempts at explaining, quantifying and managing risk, the best explanation has been simply provided by Elroy Dimsen of the London Business School:
“Risk means more things can happen than will happen.”
Make sure you are fully aware of the risks when investing. You will not achieve this awareness from a few meetings with a financial adviser, but only by taking control of your wealth.
To provide you with a broad overview of the risks inherent when investing, I am writing the e-book Don’t Lose Your Shirt, which should be essential reading for anyone who wishes to maintain and enhance their savings.