Redefining what risk means to you

Everywhere you turn there is risk. Many people take certain risks for granted, but remain terrified of other risks. Some risks are well understood and there are other risks to which we remain oblivious.

Working for the same company may seem secure and stable, but there is a risk as people who spent much of their working lives at companies like Enron, Bear Sterns, Lehman Brothers and Clico have found out, yet most are oblivious to this risk. Taking a loan from the bank has risk as it involves the repayment of an obligation in the future. The future is unknown and taking on a debt even when prospects for the future seem good could lead you to bankruptcy if the future does not turn out as expected. Yet most take this risk for granted. 

Owning stocks carry risk and most people are terrified by this risk. The reason for the fear is due to people’s misperception of risk. For many risk is layman’s speak for “losing money”. When a client says they don’t want to take too much risk, they are ostensibly saying to me they are not prepared to lose money on their investment.

What remains undefined in the discussion is what constitutes a loss. Many people own a home, but are afraid of purchasing stocks. However, both real estate and stocks are asset classes where the price goes up and down over time. Taken at any point in time, it is possible to experience a loss in both asset classes as was clearly noted when the US housing bubble burst from 2007 onwards.

The fundamental difference between the two asset classes is one (stocks) has regularly quoted prices so the price movements are known and the other (real estate) is held over a long time horizon so there is sufficient time for price movements to have an upward bias which ultimately leads to profit.

Friend in volatility

If we were to view stocks through the same lens as real estate and ignore interim price movements and hold selected stocks for the long term, then the perception of risk that causes investors to panic is removed from the equation. That perception of losing money is really volatility. When an investor says that they are afraid to take risk (lose money), what they are actually saying is that they are scared of volatility.

The irony is that before you become invested you will find many instances where volatility is your friend. If a market or stock is up, say 20 per cent, most will await a “pull back” before committing funds to that asset. If the price comes down as you hoped for, then the price action represents a movement up then down with the expectation that it goes back up again. 

This is the definition of volatility and such volatility provides an entry point for you to acquire the asset at a cheaper price. Once you own the asset, volatility provides the opportunity to add to your initial purchase all other things being equal.

Volatility is feared because it represents uncertainty, but uncertainty only exists where the distribution or probability of where prices will end up is unknown. So long as you have recognisable parameters of where prices should go, then volatility is your friend. 

Take last week’s example regarding Apple stock. 

The stock has fallen 40 per cent from around US$700 to US$420. Approximately US$150 per share is held in cash, so an investor is able to set a floor price. Similarly, a basket of stocks cannot go to zero. 

If the T&T Stock Index were to go to zero, then you have bigger problems to deal with. The point is that if you understand the parameters that you are working with, then volatility translates into temporary losses, which allow you to better, manage risk.

Base principles

Let us establish two principles. The first is that, ultimately, money is there to be spent. The second is that investing is about deferring today’s expenditure to a future date with the expectation that your purchasing power will be greater in the future on account of having made the investment.

Taking those two principles on board now permit me to redefine risk. When dealing with your individual circumstances, risk speaks to two issues. The first is the risk that you will outlive your financial resources. This means that the money set aside to take care of your needs post retirement runs out and you then have to depend on the goodwill of others (family or the State) for your sustenance.

The second is the lack of financial resources to allow you to accomplish desired goals during your lifetime. This comes about primarily because of three scenarios that are not mutually exclusive. A lack of financial resources comes from not earning enough, not saving enough or not putting your savings to work hard enough. 

In reality these are the only risk factors that we need concern ourselves with during the course of our investing lifetime. Understanding risk as described above means that you should be asking yourself, “how do I invest?” as opposed to the usual “where should I invest?” or even worse, “when should I invest?” It means the emphasis should be on seeking investment solutions as opposed to seeking to purchase investment products.

Change old labels

In practical terms, that means throwing off old labels like, “I am a conservative investor” and it also requires a reconsideration of what are considered “safe” asset classes and what is considered “risky.” Here “safety” and “risky” are a function of price rather than a character inherent in any single asset class. The financial crisis of 2008 should have at the very least taught us there is no such thing as a perpetually “safe” asset class.

The average person will consider bonds to be a “safer” asset class than stocks. So if the issue is “safety” and the question is “where should I invest?” then the answer is “to invest in bonds”. However. bond prices are very expensive, quite possibly the most expensive they have ever been. 

Purchasing a very expensive asset obviously limits the returns going forward. If your upside is limited then you run the risk of running out of cash down the road or having insufficient cash to meet your lifetime goals. 

Changing the question to “how should I invest?” means you no longer look at things in absolutes. It is no longer a question of stocks or bonds or mutual funds; the issue now turns to the combination of stocks, bonds or mutual funds that will allow you to manage the two risks defined above. 

If the issue was about investment solutions rather than investment products, then you move away from asking, what investments do you have to offer or what do you have to sell and move towards advisers that can provide an investment solution to a particular invest need.

A typical solution will mean creating a portfolio as opposed to a series of ad hoc one off investment purchases. It will mean establishing a tactical approach so that volatility becomes your friend rather than something to fear. 

For example, even though bonds may be expensive, it can and does contribute specific characteristics to a portfolio. 

A tactical approach means adjusting the exposure to bonds, depending on the circumstances. Even within individual bonds, tactical solutions will means using volatility to buy, sell or buy more within a particular price range.

During the course of last year, the ten-year US treasury bond traded at the very low yields of 1.5 per cent. Such a low yield over such a long time represents a very expensive security. It is my view that the US ten-year will trade in a range of 1.75 to 2.25 per cent this year. Establishing this probability of outcomes removes uncertainty and allows a portfolio manager to increase the allocation if yields were to rise and reduce the allocation if yields were to fall. 

These are the activities that will ultimately address the risks that I have defined above. In the end you must ask yourself whether you fear volatility (losses due to price fluctuations) more than you fear not being in control of your financial future.

At the end recognise that markets are volatile and correlations between asset classes are more unstable than at any time in your investment lifetime. Note that because of artificial support to various asset classes we have borrowed returns from the future. It means that you have to set realistic expectations and invest to your objectives or risk losing it all.

Ian Narine is a broker registered with the Securities and Exchange Commission.