Paul Winkler: Welcome. This is “The Investor Coaching Show.” I’m Paul Winkler talking about money, investing, and financial planning.
Talking About Risk
One of the things we often hear when we talk about investing is that we need to control risk. People worry about certain types of investments because of the risk of those investments, but what are we talking about when we talk about risk?
As it turns out, there are a lot of different things. Typically what happens is risk is used as a tool to get you to buy something you probably shouldn’t be buying, because we know that we’re affected by our emotions and emotions drive decision making.
When fear comes into the picture, it’s fight, flight, or freeze.
Run like heck run for the hills, because there’s risk. Part of our brain is designed to protect us from risks. So when we look at, let’s say the hope for gain, that doesn’t have nearly the impact.
This happens in the investing industry all the time. You’ll hear of some fund manager who has hit it big. People look at that and say it was skill, but I look at it and see mere luck. How do you know it’s luck? Well, if you look at professional fund managers, such a tiny fraction of them end up getting higher returns than the market.
In other words, when they have returns come in, they exceed which stocks historically? Markets grow and companies go up in value. Microsoft is not the same company size-wise that it was when Bill Gates pulled it out of the garage.
We look at Apple, Amazon, and all of these companies that have grown tremendously and grown in value, but we didn’t know those companies were going to be the winners.
People say in hindsight that it was obvious a certain company was going to be a winner, but it’s not obvious. When people come out of the woodwork looking for a winner, it doesn’t end well. Fund managers that suddenly hit it big usually crash and burn after that.
Look, this is really what’s going on here, guys. It’s not necessarily what you think. So when we look at that and we look at risk and we say, well, markets have risk.
Volatility
So let me bring it back to the original point. Stock markets have risk and everybody gets that. When an academic talks about risk, well, some of them are a little bit off the beaten path, but typically what they’re talking about is the level of volatility.
Volatility is how much this thing can go up and go down and back and forth.
It is how much it might oscillate, and we want to know how big are those oscillations? How big are the ups? How big are the downs? When we look at that, how do we measure that? Well, we measure that to standard deviation. How much does it deviate?
In school, you took classes on math and learned about statistics and you learned about the bell curve and you learned that nature has this thing going on where you look at anything, maybe it’s the height of trees, and you say, well, there’s an average height of a tree around the world.
Some are really small, way on the left-hand side of the bell curve, and some are super tall. If we’re talking about flipping coins, it’s the same thing. The distribution is that most people are going to be somewhere in the neighborhood of flipping 50% heads and 50% tails. You’ll have some that are really, really far on one side or really far on the other side, flipping 95% heads and 5% tails.
Well, in stock markets you’ll have average returns, but you’ll have deviations from that. Now, if you look back through history, small companies have never had a 12% return, close as it was in 1950. Well, what is that? That’s the average return.
Some years it’s 40% positive and other years it’s 20% negative. It’s come into that average right there. So if we look at that and see the distribution, that’s what we call risk.
Now when you look at securities regulators, they are really quick to make sure that financial people talk about risk in investing in terms of the risk that your return will not be what you expect it to be, which is absolutely correct.
That is one type of risk and it is something that we ought to pay attention to because if you look at history, yeah, you’re not going to see that the returns come in for stocks. They almost never come in at that average return.
The Typical View of Risk
Then the other aspect of risk is this. The one we typically think of is losing all our money. Now, when we look at individual stocks, there is a tremendous risk of losing everything because what happens if a company cannot pay its bills?
They’ve borrowed money, they’ve got bond holders. Well, the bond holders get their money back first, and if they have to liquidate everything, they’re going to have to liquidate everything to pay off the bond holders. Then the problem is you don’t have a company anymore, you’re in bankruptcy, and your stockholders get nothing.
Then you’ll have sectors of the market that may go away. You may look at the technology at any point in time and go, this is great stuff, this is wonderful, and then new technology comes over and makes the old technology obsolete, then you’re sunk again.
So you can have that, or you can have people borrowing money to buy stocks and that’s leverage and you can lose all your money that way. When we’re talking about risk in stock markets, when I’m talking about it, I’m wanting to be diversified globally all around the world with all different size companies, tens of thousands of them.
The likelihood of all of them going bankrupt at once would be pretty slim. Could it happen? Yeah, you could have global thermonuclear war and then all bets are off with anything.
So that’s one type of risk and that is disclosed, we talk about that in prospectus, past performance. There’s no guarantee of future returns. Now, by the way, that’s really important when you’re looking at professional managers trying to beat the market. What they’ve done well in the past doesn’t mean anything.
It would take 60 years to tell whether somebody’s performance was due to skill or luck.
Eugene Fama said that. A person will be dead or retired by the time we can know for sure.
And then you’ve got the other aspect of things. The other side of the deal is that when people think about a non-risky investment, they see it as guaranteed.
You will see that insurance companies advertise that their products are guaranteed. You’ll have banks, FDIC guarantees, for example, you’ll see that and you think, well, that has no risk of any kind of loss, right?
Insurance Companies and Bonds
Well, the reality of it is your risks fall into different areas when it comes to those types of things. Now, instead of the risk, let’s take the insurance company for example. What is the insurance company? The insurance company is an intermediary.
In other words, when you put money into an annuity product or an insurance product or any kind of financial product sold by the insurance company, they take that money and reinvest it in risky securities.
So have you really truly avoided risk? Not really because they have to put the money into bonds and real estate. Increasingly, I’ve talked about how one study showed that insurance companies had 30% of their assets in junk types of bonds.
That’s a lot. Those are bonds where money has been lent to a company in some financial distress. So you look at that and say, how could they say that it’s guaranteed that it’s protected? Well, they’re allowed to say that, but the reality of it is, do we still have risk? We still have a risk of default.
Now if all of a sudden all the insurance companies out there, invest very similarly and the types of things that they invest in there’s a problem. People worry about the dollar devaluation or federal debt or insurance companies issuing other products and having higher claims than expected or people wanting to get their money back out.
Then what happens? All of a sudden they go, wait, wait, wait. Your money isn’t sitting in a bank, it is invested in some other thing.
Remember, banks are a go-between for you and where your money is ultimately invested.
Where’s your money invested? It’s sitting in somebody’s house, it’s in somebody’s business, it’s in somebody’s car. Yeah, we saw that this isn’t pie in the sky stuff. Can something go wrong where the businesses, maybe the banks, made bad loans. Can something happen where the bonds go down in value? Silicon Valley Bank, perhaps?
There is risk at all times. That’s a point I like to make to investors because there’s a generation of people who have never seen a decline in the bond market. This is a long time ago. I said, there’s a generation that’s never seen it.
Interest Rates and Inflation Risk
Why? If you look at interest rate history, you’ll see that in the early 1980s, the interest rates were very, very high. And what they did is they came down. Well, what do we know about the nature of bonds and interest rates?
There’s a reciprocal relationship if interest rates go down, bond prices go up. The reason being is that the old bonds pay the lower interest rate, if the interest rates were high, they become worth more. So what happens? People see that interest rates have gone down, but there’s an old bond that pays a much higher interest rate.
Well, you’re going to have to pay a premium or pay more than the par value is what it’s called to actually buy that bond. Bonds are issued for a thousand dollars and then they mature for a thousand dollars. If interest rates go up, then all of a sudden that bond becomes worth more. It may be worth $1,020 or something like that.
Now eventually it’ll come back to earth, it’ll come back to a thousand when it matures. And that is what’s happening is it’s making up for the fact that the new interest rates out there, the newly issued bonds are paying lower interest rates.
There’s no free lunch out there. I haven’t even brought up inflation risk.
There is no such thing in the investing world as being without risk.
So when I said the whole generation of investors, they’ve never seen a decline because interest rates went from a high in the early 1980s down to a historic low.
So what happens? Bond prices go up. So a lot of people became complacent. They were looking at the past performance of bonds and they were going, “Look, this is really good compared to the stock market. It’s a little bit less, but so much less risky. People are starting to load up on that in their portfolios.
I thought it was kind of crazy and not the best idea ever. Then of course what happened is interest rates went up. Now I didn’t know when that was going to happen. There was no way to know that.
But the point was that you might go a long period of time where the status quo remains the status quo, then you become complacent which can lead to mistakes.
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