Sound Investing 3: Risk

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Accept reasonable, but not unreasonable risk

All investment entails risk because we can’t know the future with certainty. We try to anticipate the future, based on our experience of the past, but any expectation could be invalidated by unforeseen events. Any dollar you invest could conceivably disappear, but that’s a risk that any investor must accept. What we can do is distinguish more reasonable risks from less reasonable ones.

Being alert to risk

The first step is to be aware of what kinds of risks exist. Some risks are very obvious, such as the risk that a stock will go down, or that a company might default on its bond obligations. Other risks are more subtle. You can invest in something that’s extremely safe, such as US treasury bills, but earn such a low return that you can’t keep up with inflation, so the real value of your account is actually declining.

One type of risk that can be especially confusing is the risk of fluctuating bond prices due to changes in interest rates. Suppose you buy a 20-year bond paying 7% interest. You have the security of collecting that 7% interest every year. But suppose interest rates rise and new bond issues of the same type are now paying 9%. If for some reason you would want to sell your bond before it matures, you would have to sell it at a discount to its face value. Otherwise, who wants to buy your 7% bond, when they could buy one paying 9%? The farther your bond is from maturity, the more you will have to discount it to make it attractive. Longer-term bonds are inherently riskier than shorter-term bonds because they lock in an interest rate for a longer time. They fluctuate more in market value when interest rates change.

The volatility of an investment–how much it varies in value under different market conditions–indicates its risk. In general, stocks are even riskier than bonds, because they fluctuate even more in market value. Stock indexes such as the Dow Jones Industrials or the S&P 500 can easily lose a third of their value in a bear market. (They lost 33.8% and 38.5% respectively in 2008, their worst showing since the 1930s.) Individual stocks can lose even more when individual companies have a bad year.

Risks and rewards

Some investors find the risks of investing intimidating. They are what we call “risk averse.” They are so afraid of losing money that they confine themselves to only the safest of investments. As a result they miss out on many of the rewards of investing. Successful investing requires us to take calculated risks, risks that are justified by a reasonable expectation of reward. The extra reward that you should get from accepting more risk is what we call a risk premium.

The reason why people are willing to accept the risks of stock investing is that stocks have outperformed bonds on the average over the very long run. The reason why people are willing to accept the risks of intermediate or longer-term bonds is that they usually offer higher interest rates than short-term bonds. Companies with lower credit ratings also have to offer higher interest rates as a risk premium on their bonds. So bonds are rated according to credit-worthiness. In the Standard and Poor’s ratings, for example, the most secure bonds are AAA, followed by AA, A and BBB. Those are the ratings considered “investment grade.” Bonds with ratings below BBB are often called “high-yield” bonds because of their higher interest rates, and they are also known as “junk bonds” because they are issued by financially shakier companies. Some investments are so risky that even the possibility of high rewards shouldn’t convince you to bet very much of your money on them.

Different kinds of investments fall along a continuum, with low-risk/low-reward investments at one end and high-risk/high-reward investments at the other end. At the low end are the least volatile of investments, such as insured bank deposits, treasury bills and money market funds. They are very safe, but earn very low returns. At the high end are very speculative investments such as precious metals, collectibles, commodity futures and stock options. They can earn spectacular returns, but they are so volatile that ordinary investors should approach them with great caution. In the middle are the investments from which most investors make most of their money: stocks, bonds and real estate. Bonds lie more toward the conservative end of the continuum, with shorter-term bonds more conservative than longer-term bonds. Stocks and real estate tend to be higher than bonds on both risk and reward. Small-company stocks are riskier than large-company stocks, but on the average have generated higher returns. That is especially true for small-company stocks that are priced low relative to the book value of the company’s assets (so-called “value stocks”), probably because the low price implies uncertainty about future earnings, but also provides potential for price appreciation.

Distinguishing reasonable and unreasonable risks

Much of investing consists of taking reasonable risks and being rewarded for doing so. On the other hand, you should avoid unreasonable risks, risks that are not justified by a risk premium. You can think of unreasonable risk as basically gambling. On the average, you get no reward from playing the slot machines, since the total amount paid out in winnings is less than the total amount gamblers put into the slots, after the casino takes its cut. You could come out ahead if you are unusually lucky, but a rational calculation indicates that in the long run you will come out behind. Playing the slots is what’s called a loser’s game.

Betting on horse races is also a loser’s game for most bettors, although strictly speaking it doesn’t have to be. In theory, a bettor with extraordinary knowledge of horses might be able to beat the odds. But most bettors have to rely on what is commonly known about the horses, especially their track records. Everybody knows who the favorites are, and they’re bet so heavily that it’s hard to make much money on them. If you bet the “dark horses,” you’ll win big when you win, but you won’t win very often. The average bettor has to lose money, because the track pays out less in winnings than it takes in in bets. So for most bettors in the long run, it’s a loser’s game. Some people get a kick out of playing loser’s games. They are willing to accept the risk of losing in order to have the possibility (as opposed to the rationally calculated likelihood) of winning. But they are gamblers, not investors.

Stock investors vs. stock gamblers

What kind of game is stock investing? Investing in the stock market in general is not a loser’s game, because the companies whose stock is publicly traded usually make money (at least in the aggregate, with the gains of some more than offsetting the losses of others). Their shareholders get the benefits either in the form of dividends or share appreciation, or both. Nevertheless, many market observers have come to the conclusion that betting one’s money on particular stocks is a loser’s game for most investors, especially if the number of stocks selected is very small. To understand the reasoning behind that conclusion, we have to make a distinction between the risk premium that investors usually get from investing in stock in general, and the risk premium they may or may not get from investing in a particular stock.

Consider two groups of investors. Group A consists of all the investors who own shares in the Vanguard Total Stock Market Index Fund, a mutual fund that owns stock in virtually every publicly traded company. Group B consists of all the investors who own shares in any one publicly traded company, but only one company. Let’s assume that stocks have a reasonably good year, and the index fund generates a 10% return. Every investor in Group A took on the same risk (that the market as a whole might go down) and got the same reward for doing so. But every investor in Group B took on the additional risk that their particular company would underperform the market as a whole. They could easily lose money by betting on the wrong company. Were they rewarded for their additional risk? On the average they couldn’t be, since their average return remains around 10%. (Group B does have the advantage of not having to pay the mutual fund’s annual expenses, but we will ignore that since the expense ratio of this index fund is well under 1%.) For every investor who was smart enough–or just lucky enough–to pick a stock that returned more than 10%, there must be another whose stock returned less than 10%. Wall Street is not Lake Wobegon, where “all the children are above average.”

The fact that the average investor gets no risk premium for trying to pick individual stocks does not prove that no investor gets a risk premium for doing so. In theory, a stock-picking expert should be able to beat the market, just as a horse expert should be able to beat the odds in horse racing. But both logic and evidence suggest that this is much harder than most people think. It’s not enough to “bet the favorites,” that is, just invest in companies that are well known for their strong financial track records. Those companies may have the best earnings prospects, but they also carry high price tags. Back in the 1960s, most people thought that IBM was a good bet, since it was the leading computer company. And over the next four decades, its earnings did grow at an above-average rate. But investors who bought the stock in the 1960s paid so much for it that their percentage return on their investment actually turned out to be below average.

What a stock-picking expert needs is an extraordinary ability to spot bargains, to identify companies that will perform surprisingly well and turn out to be worth more than the masses of investors think. What really moves stock prices are earnings surprises. But surprises are by definition hard to anticipate, and unpleasant surprises are just as common as pleasant ones. Anticipating results that are surprising to everyone else cannot be a very common ability. The evidence bears this out. Not only do most ordinary investors fail to beat the market in the long run by trying to pick individual stocks, but so do most professional stock pickers, including most mutual fund managers and publishers of newsletters giving advice on which stocks to buy! (A later post on investment fees and expenses will discuss this finding further.)

What about a legendary stock picker like Warren Buffet? He does place heavy bets on individual companies, and he has been richly rewarded. Does he think that most ordinary investors should try to do what he does? Absolutely not. Most of us lack the time and the ability to pick companies as astutely as he does. If we try, we will be taking on additional risk by gambling too much on too few securities, without a reasonable expectation of an additional return. Buffet himself thinks we would be much better off managing risk by investing in highly diversified funds and settling for an average market return. Diversification is the topic of the next section.

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