Most investors incorrectly think of “risk” as the chance that the market value of a financial asset will fall below the amount he or she has invested in the asset. My God, how could this be happening!
Think about it. Harboring these misconceptions (that the lower market price = loss or bad and/or that the higher market price = profit or good) is the biggest risk-creator of all. It invariably provokes inappropriate actions within the great mass of individuals who are not initiated in the ways of the investment gods.
Risk is the reality of financial assets and financial markets: the current value of all securities will change, from “real” ownership to time-bound future speculation. Anything that is “saleable” is subject to change in market value. It’s as the gods intended, and portfolios can be designed so that it doesn’t matter as much as you’ve been brainwashed into thinking.
What is abnormal is the hype surrounding changes in market value and the hysteria such hype provokes among investors. There’s no way a weak housing market should translate to almost zero inflows on the bank balance sheet — it just doesn’t count, except when it comes to popular politics.
Similarly, the reality of financial shock cycles (market, interest rate, economy, industry, etc.) simply do not fit the backward-looking, but popular and generally accepted, calendar-year assessment mechanisms at all. Brainwashed again.
The amount, cause, frequency, range, and duration of the change in market value will always vary in an unpredictable “I don’t care who you listen to” manner — the certainty is that the change in market value of investing assets is inevitable, unpredictable and essential to long-term investment success.
Without these natural changes, there would be no hope of profit, no possibility of buying low and selling higher. No risk, no profit, and no thrill — boring!
The first steps in minimizing risk are cerebral and involve developing an understanding of the fundamental economic purpose of the two basic classes of investment securities.
From the investors’ perspective: (a) equity securities are expected to produce growth in the form of realized capital gains, and (b) income securities are expected to produce spendable (or reinvestable) income. But it is not real growth until it is realized, or real income until it is received.
Alternative investments? These are the contracts, gimmicks, products, hedges, and other creative ideas that college textbooks used to call speculation. Once upon a time, trustees, trustees and unsophisticated people were not allowed to use them. The stigma is gone, but artificial demand adds risk to all markets.
They’re especially risky for the millions of 401(k) and IRA investors who probably can’t explain the difference between stocks and bonds, from any perspective. Most investors have virtually no idea what is actually being done within the products they select, and even less interest in learning about it. They dance to the rhythm of daily media rumors.
Wall Street knows this and takes advantage of it mercilessly. Despite the recent financial crisis, pension plan trustees (particularly in the public sector, go figure) are turning to throw money at the same alternative and derivative speculations that crashed the market a few months ago.
401(k) participants are force-fed daily menu items from self-serve vendors who make little effort to identify risk, let alone minimize it. Very few plans allow participants to develop an understanding of their investment options with only education provided by the product providers themselves.
What happened to stocks and bonds, the building blocks of capitalism? Do investors recognize the financial stake they have in the very corporations their elected officials are encouraged to tax, restrict and regulate into competitive mediocrity?
Another mental step in risk minimization is education. You just can’t afford to put money on things you don’t understand, or the salesperson can’t explain to you in English or Spanish or French or whatever.
Of course, I’d rather skip this step and jump right into some new athletic shoe products that will help you get through the work and straight into the profits. How did it go? It was once written (somewhere): no work, no reward.
The risk is compounded by ignorance, multiplied by trickery, and exacerbated by excitement. It’s halved with education, improved with cost-based asset allocation, and managed with discipline: quality selection, diversification, and income rules: the QDI.
Real financial risk in stocks boils down to: the chance that a company’s stock (that 30% stake in your brother-in-law’s pizzeria) will lose value as management succumbs to economic forces and/or mandatory costs imposed by external entities whose edicts must be complied with.
In debt-based securities, the risk is: the chance that the issuer of an interest-bearing note (the money your spouse lent your brother at 6% to start serving pizza) will stop or fall behind on your payment obligations and/or declare bankruptcy and clear interests of both the owner (shareholder) and the creditor (bondholder).
Here’s an interesting risk in equity markets, one that governments have wisely refused to address for fairly obvious reasons. The “Masters of the Universe” routinely receive obscene amounts of compensation for risking OPM (other people’s money) perhaps too arrogantly.
The company goes bankrupt, shareholder interests become worthless, debt obligations are worthless, while the bigwigs keep piling up, even suing to preserve their bonds. Boardroom corruption and direct lobbying (another euphemism, for bribing) of elected officials are two additional risks investors should be aware of.
Google: Part II – Cruise Control Coverage: The Basics of Investing
Steve Selengut