Not All Risks are Created Equal

The risk you need and the risks to avoid

Risk is fundamental to almost every decision we make.

When we try a new restaurant, we weigh the opportunity for a memorable dining experience against the risk of getting mediocre food or spending too much. When we take a day off during a big project, we balance the pleasure of a day’s rest against the risk of being seen as uncommitted or unreliable. We constantly weigh risk and reward, whether consciously or not.

Risk can be stressful, but without it, life is hardly worth the effort. Risk is the price we pay to acquire or achieve something we couldn’t otherwise reach. Risk opens the door to opportunities that may be better, faster, cheaper, more lucrative, or more satisfying than risk-free alternatives.

This is especially true in investing. Risk is the straw that stirs the investment drink. Without risk, an investor would find no opportunity for return beyond the nominal return of passbook savings. Without risk, an investor can’t turn a dollar into much more than a dollar, but an investor willing to accept the possibility of a loss may earn the opportunity for a significant gain.

Select risks carefully

But not all investment risks are created equal. Some risks create the opportunity for higher expected returns; others do not. Recognizing the difference is crucial.

If we think of investing as a car race, some risks are worth taking for the chance to win. For instance, a driver intent on earning the trophy may need to run the car near its mechanical limits, pass in tight traffic, and skip a scheduled pit stop. These risks can clearly improve the driver’s placement and payday…but may also lead to a crash or poor finish.

But some driving maneuvers only increase risk without increasing expected reward. For instance, driving with one’s eyes closed or randomly swerving from side to side greatly increase the range of bad outcomes, but offer little or no prospect of finishing higher in the results.

Investors who knowingly take on greater risk without the potential for proportionally greater financial reward are essentially cheating themselves – paying more for a product than its apparent value. They may justify their choices through other non-performance rewards, such as thrill of beating the market now and then. This, of course, is more about gambling than investing.

Risk with reward

So which risks are “worth it?” Risks that raise expected return are referred to as compensated risk. Investors accept greater chance of a loss in exchange for a higher expected return.

For instance, stocks face market risk – they rise and fall with economic, political, and technological developments. As such, stocks are generally riskier than bonds, and far riskier than holding cash in CDs or savings accounts. In return for the greater risk, stocks over the long term typically have greater returns. The added expected return compensates investors for the chance of loss they may experience.

Likewise, bonds expose investors to credit risk – the chance that the issuer will not make payments of interest and principal as scheduled. Bonds also carry interest rate risk – the chance that rates will rise and reduce the bond’s inherent value. Because of these risks, bonds typically deliver higher returns than cash held in savings. Investors need these risks to beat the low but safe returns on cash.

Uncompensated risk

Some risks, however, are not compensated; that is, the investor is not rewarded for accepting a wider range of outcomes. One of the most important examples of this is company risk, single stock risk, or stock-picking risk. While trying to pick stocks that will outperform their peers has been a staple of investing for many generations, its risk/reward trade-off is suspect.

Consider two portfolios of equal value. The first holds 100 randomly selected large company domestic growth stocks. The second contains just one large company domestic growth stock, ABC company, handpicked by an investor or broker.

Research tells us two important things about these portfolios. First, their long-term expected performance will be similar. Landmark studies by Brinson, Hood and Beebower (1991) and Ibbotson and Kaplan (2001), indicate that asset allocation explains more than 90% of portfolio performance, far more than any other factor. Because both portfolios contain securities from just one asset class – large company domestic growth stocks – we can expect the value of both to move generally in the same direction at a similar pace over the long term.

Second, we can expect the single stock’s performance chart to be much more erratic or jagged than that of the 100 stock portfolio. ABC company will be subject to short-term company- and industry-specific influences, such as new regulations, strikes, product demand, recalls, and technology advances – that may make its returns jump one year and dive the next. But in the 100 stock portfolio, some stocks will rise when ABC falls, and vice versa, muting the short-term impact of any single political, economic, or technological development. The risk of a large short-term loss in ABC is, on average, greater than for the 100 stocks.

These two ideas taken together – asset class is the primary determinant of long-term performance and an individual stock is, on average, more volatile in the short term than its asset class – means that a stock picker assumes greater risk without the compensation of greater expected return.

In the example above, owners of both portfolios might expect an annualized return of 8 percent over many years. Neither portfolio would be expected to gain exactly 8 percent every year, of course. Both performance charts are likely to show significant jumps and stumbles, but the owner of ABC should expect to endure far wilder fluctuations year to year than the 100 stock portfolio owner. These wide fluctuations can be stressful, and, if the investor in ABC must sell during a losing streak, expensive.

Taken to the extreme, consider the greatest danger of all in stock picking – putting all one’s money on an Enron, AIG, or GM. As all investors have learned in recent years, the value of seemingly robust companies can slide or collapse with little or no warning. Clearly the chance of one company losing all its value is far greater than that of 100 companies in different industries and with different management teams doing so. With the chance for a home run comes the chance for a devastating strikeout.

The risk of missing out

Like stock picking, market timing is a very common investment strategy where the investor assumes uncompensated risk. This practice – trying to jump into the market before it goes up and back out before it declines – sounds appealing, but there is no evidence that market timing can be systematically utilized over the long term to improve investment returns.

Market timing provides no systematic reward, but does introduce a big risk: being out of the market when it makes a major advance. Missing just a small number of big up days means falling well behind buy-and-hold market performance. The S&P 500 returned 8.4% annualized from 1989 to 2008, however, market-timers who missed only the ten best days in those twenty years would have achieved only 4.9% annually. (Morningstar).

Market timing and stock picking can be thought of as “risks of bad behavior” – like unforced errors that hurt performance in a tennis match.

Risk hiding in plain sight

Another important and often overlooked risk is inflation or purchasing power risk. Inflation has averaged a little less than 3% a year since 1990, and about 3.4% since 1913 (inflationdata.com). This sounds like a small factor, but inflation is the high blood pressure of investing – an insidious silent killer. Inflation doesn’t directly reduce the balance in an investment account, just its spending power. The real return of a five percent bond in a three percent inflation environment is a scant two percent when it comes time to spend the money. And double digit inflation spikes can cripple seemingly sound retirement cash flows.

The longer the timeframe, the more dramatic the risk associated with inflation. Consider that goods and services that cost a dollar in 1958 now cost more than seven dollars (inflationdata.com). Investors hoping to build a nest egg for retirement must recognize and proactively address the erosive effect of inflation. Ignoring it means accepting risk without any return.

In investing, risk takes many forms. Some are well known. Some present opportunity. Some do not. Some are ignored, discounted, or misunderstood. Every investment decision should be made with eyes wide open to all varieties of risk, with the goal of accepting only those that compensate the investor with corresponding potential reward.

© 2010 Bright Sky Group, LLC. All rights reserved.

Bright Sky Group, LLC is not a registered investment adviser. The views expressed by Bright Sky Group represent the opinions of members of Bright Sky Group, but should not be construed as financial or investment advice. Further, the views are subject to change and are not intended as a forecast or guarantee of future results. The material provided by Bright Sky Group is for informational purposes only. Statements of future expectations, estimates or projections, and other forward looking statements are based on available information deemed reliable, but the accuracy of such information cannot be guaranteed. Statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results.

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