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Components of Investment Risk

The risk/reward relationship is likely the most fundamental concept of finance. But “risk” is such a vague term that I think it can be helpful to break it down into more tangible components.

Time as a Component of Risk

When it comes to money, time is a key ingredient. It can take an otherwise very risky investment and make it significantly less risky–possibly even conservative.

For example, a friend of mine is buying a condo in Manhattan. While prices have come down recently, they are still astronomically high. My buddy is worried about buying this condo because he fears that prices might drop. If he does buy the condo, the reward is pride of ownership and (possibly) a good long-term investment. But the risk that he’s thinking about is the risk of overpaying for his pad.

Why is he thinking about that?

He’s completely forgotten about the element of time. He’s not going to sell his condo this year or next. He’s not going to fund his down payment by going into credit card debt. He’s got the cash just sitting there. And the odds are, he’ll hold on to that place for the next 20 years. It doesn’t matter what the price of the condo does over the next few years because that will have no impact on him.

When you think about risk and reward, don’t forget about time. Consider your risk over your intended or likely time frame.

Probability of Loss

The next component of risk is probability. Yes, it’s important to understand what a bad outcome might look like, but in order to make a good decision, we have to be mindful of the chances of something catastrophic happening.

Think about driving your car. There is always the possibility of getting into a terrible accident when you get into an automobile. But the odds of a catastrophic accident are so remote that most people don’t have a problem getting into a car and driving downtown.

Investments are no different. When you make an investment, there are always risks. You can take steps to reduce those risks, but you can never eliminate them. Because risk exists, does that mean you shouldn’t take action? It may…if the probability of that bad outcome is significant. But if the probability is very low, you (usually) shouldn’t let it stop you.

Magnitude of Loss

The final component of risk is magnitude. The odds of something happening might be very low, but the magnitude of the consequence might be so great that you still can’t take the chance.

Consider robbing a bank: Even if you have what appears to be the perfect plan, it’s a bad move. The idea of going to jail is so repulsive that it makes the proposition a non-starter. In this case, the magnitude of the consequence is so high that it almost doesn’t matter that the odds of experiencing that negative outcome are low.

Similarly, even if you have a “sure thing” investment, it’s still important to diversify. If you put everything into one ostensibly low-risk investment and that one-in-a-million bad outcome occurs, your life savings will be history, and you won’t have enough money to retire.

When considering magnitude of risk, rather than thinking in terms of dollars, it can be helpful to think in terms of impact. For example, Bill Gates can lose $10,000, and it won’t impact him at all. He can still live on any island he likes. You might also be able to lose $10,000 without it having a huge impact on your life. But somebody struggling with debt can’t afford that risk. Such a loss would be a game-changer and, therefore, not an acceptable proposition.

In summary, when investing, you need to understand what you are risking, how likely that risk is to appear, and how the magnitude and probability of that risk change over time.

About the author: Neal Frankle is a Certified Financial Planner in Los Angeles and runs Wealth–a personal finance blog for people interested in making smart decisions about their money.

Emerging Market Risks

A few days ago, I received what I thought was a great question from a reader:

“Why are emerging market funds said to be risky? It seems to me that with countries like China or India, it’s a low risk bet that their economies will grow. It hardly seems like there’s any more uncertainty over there than there is right here at home in the U.S.”

Growth is Already Priced-In

As we discussed on Monday, every company’s stock price already includes the market’s estimate for that company’s future growth in earnings. And, therefore, the same thing is true for any particular group of stocks (such as the stocks that make up an index representing the Chinese stock market)–expected growth is already priced in.

So the risk is not that the companies in the index will not grow. The risk is that they will grow more slowly than expected.

Emerging Market Risks

And when attempting to guess the growth rate for a company in an emerging market, there are a handful of factors that cause significant uncertainty.

Accounting risk: In the U.S. and other developed markets, accounting standards are very well defined. Each transaction is recorded in a prescribed way (or one of a few ways), and financial statements are presented according to a very specific set of rules.

In contrast, in many emerging markets, accounting standards are not as thorough–the result being additional uncertainty as to the quality of information contained in a company’s financial statements. Naturally, this makes it even more difficult than usual to predict a company’s rate of growth.

Political risk: In emerging market economies, the governments themselves can often be less stable. If a country’s government is overthrown or one dictator is replaced with another, it’s nearly impossible to predict the fate of any particular company in that country. For example:

  • Will that company’s industry be popular with the new government, thereby receiving government support such as subsidies?
  • Or will that industry be unpopular, thereby incurring new taxes and fees?
  • Or will the new government nationalize the industry, thereby forcing out private owners completely?

Lack of regulation: Our regulatory system is imperfect, no doubt about it. But we have it good compared to countries in which bribes and corruption are an everyday part of the regulatory environment. Just like the accounting risk mentioned above, lack of regulation makes it more difficult to place trust in a company’s financial statements, thereby making it more difficult to accurately predict growth.

Currency risk: As with any international investment, there’s the risk that, even if it performs well, your dollar-denominated returns will be reduced as a result of that country’s currency decreasing in value relative to the U.S. dollar.

Historical Volatility

To the extent that risk can be represented as the volatility of returns, emerging markets stocks have definitely shown higher risk than U.S. stocks. (For example, Morningstar’s “risk” page shows significantly higher volatility of returns for Vanguard’s Emerging Markets Index Fund than for their Total Stock Market Index Fund.)

Should You Invest in Emerging Markets?

Despite the above warnings as to the high-risk nature of emerging markets, I don’t think it’s a bad idea to allocate a portion of your portfolio to them. Approximately 10% of my own portfolio is in emerging markets (via Vanguard’s Total International Stock Index Fund).

I just think that it’s important to know what you’re getting yourself into. 🙂

Should I Diversify Among Brokerage Firms?

I recently received the following question from a reader:

Is it OK to keep all my investments with one company? Or should I diversify among brokerage firms?

The answer is that it depends on your situation.

Quick note: We’re not talking about diversifying your portfolio among different investments. (That one is a no-brainer: Yes, diversify.) We’re talking about whether or not it’s important to keep those investments at multiple brokerage firms.

Reasons to Use One Brokerage Firm

Really, the only reason not to diversify is to keep things simple. (Though that’s a darned good reason in my opinion.) By using only one brokerage firm, you have fewer accounts to check and less paperwork at tax time. In addition, having all your investments with one company makes it easier to:

  1. See your total asset allocation at any given time and
  2. Rebalance when necessary.

Reasons to Use Multiple Brokerage Firms

There are multiple reasons why it might be advantageous to use two (or more) brokerage firms, though it’s possible that none of them apply to you personally.

You’re Over the SIPC Coverage Limit
The Securities Investor Protection Corporation (SIPC) is somewhat analogous to the FDIC–but for brokerage firms. The SIPC steps in to make investors whole when they’ve lost money due to fraud or brokerage firm failure. They explain it this way:

SIPC does not bail out investors when the value of their stocks, bonds and other investments falls for any reason. Instead, SIPC replaces missing stocks and other securities where it is possible to do so. … SIPC helps individuals whose money, stocks and other securities are stolen by a broker or put at risk when a brokerage fails for other reasons.

SIPC coverage, however, is limited to $500,000 per customer. (And coverage of cash in brokerage accounts is limited to $250,000 per customer). If you’re over that limit, it’s probably not a bad idea to spread your investments out across a couple brokerage firms.

You Need Immediate Access to Your Investments
When a brokerage firm fails, it can take several months for the SIPC to replace investors’ lost securities. As a result, if you’re at the stage where you’re drawing money from your investments (and you don’t typically keep a great deal of cash available in checking/savings), it may make sense to use multiple brokerage firms.

You Like the Offerings of Multiple Brokerage Firms
Finally, there might be reasons other than risk-avoidance for you to use multiple brokerage firms. For example, it may make sense to have accounts at both Vanguard and Fidelity if you want commission-free access to Vanguard funds, but you also want to buy TIPS commission-free in your IRA. (Depending on the size of your account and whether or not you’re buying the TIPS at auction, Vanguard may charge a commission.)

I Don’t Diversify (Anymore)

Until a few months ago, I had IRAs at a couple different places. But when the rules changed on the 2% cashback Schwab credit card to allow the cashback bonus to be deposited anywhere, I moved everything over to Vanguard.

In other words, I don’t diversify across multiple brokerage firms. And that doesn’t worry me at all. But it may make sense for you to have accounts at multiple places.

Investment Analysis: Probability and Payoff

Would you take a bet if you had less than a 50% chance of winning? It depends on the payoff, right?

For example, this is a bad bet:

  • 1/5 chance of winning,
  • $5 cost to play, and
  • $10 payout if you win.

And this is a good bet:

  • 1/5 chance of winning,
  • $5 cost to play, and
  • $100 payout if you win.

In the first scenario, for every $25 you spend, you’ll win $10 on average — not good! In the second scenario, for every $25 you spend, you’ll win $100 on average — woohoo!

Conclusion: The probability of winning or losing isn’t that meaningful without information about the consequences of winning or losing.

Active vs. Passive Investing

Most of the talk about active vs. passive investing focuses on how likely it is that an actively managed mutual fund will outperform its benchmark.

But as Rick Ferri (author of the upcoming The Power of Passive Investing) explains in this interview, probability of winning is only half the picture. For example, the fact that actively managed funds have only a 1/3 chance of outperforming the market over a given period doesn’t necessarily make them a bad bet. If, when they outperformed, they outperformed by 10-times the amount by which the losing funds underperformed, it would make sense to try to pick market-beating funds.

But — and you probably guessed this — they don’t. In fact, they don’t even come close. And that is why attempting to pick market-beating funds is a losing bet.

Retirement Investment Strategies

Similarly, much of the writing about retirement investing strategies tends to focus on how likely it is that a given strategy will result in the investor running out of money. For example, you might read that Strategy X has a 10% historical rate of failure over 30-year periods (that is, 10% of the time, somebody following the strategy would have run out of money).

Surely that’s helpful information, but it’s also important to note at what point the investor runs out of money. Did it happen in year 29 or in year 15?

  • If the failure occurred in the final years, it might not have even happened in a real life situation. An actual investor (as opposed to a computer running through hypothetical scenarios) would probably trim his/her spending once it becomes obvious that cash is running low.
  • On the other hand, if the failure occurred in year 14 or 15, that’s a problem. It takes a lot of trimming to stretch a budget for an extra 15 years.

Probability of Success (or Failure) Isn’t Enough

When you’re reading about investing, remember that probability is only half the picture. Before concluding that the X% success rate or Y% failure rate that you see quoted in an article is good or bad, be sure to find out what “success” looks like and what “failure” looks like.

Retirement Savings vs. Income Growth

Over time, I’ve learned that you folks are a sharp bunch. So I thought I’d pick your respective brains on a not-so-hypothetical question I’ve been struggling with:

How do you balance investing for retirement against investing to increase your current income?

For me, such income-increasing investments would be business-related: advertising, outsourcing articles, or faster hosting, for example.

If you’re not an entrepreneur, such investments would likely be career-related: picking up an important certification or attending conferences where you could make valuable contacts, perhaps.

Go for Higher Returns?

The reason I struggle with the question is that, in my experience so far, the money I’ve invested in my business has earned returns significantly greater than what one could expect from the stock market. Of course, many investments don’t pan out as hoped, but if I try enough things, one of them usually pays off nicely.

And from what I’ve seen, that seems typical of many career-related investments as well. A few hundred dollars here or a couple thousand dollars there can sometimes lead to a raise of that much per year — for the rest of your career.

Factoring in the Risk

Yet, most people don’t put all of their money into business or career-related ventures. (And I have no intention of doing so either.)

The reason, of course, is that such things are relatively high-risk. The greater the portion of your total net worth that’s tied up in one asset (whether a business or a career), the more exposed you are to an event that impairs the income from that asset.

Also, eventually, retirement isn’t optional. There comes a point where your body just isn’t willing to work (or work as much). Saving for that day is important, regardless of how much you enjoy your work and regardless of what return you can get by investing in your business or career.

What’s Your Method?

Between two Roth IRAs, a solo 401(k), and my wife’s plan at work, we’d be eligible to invest more than $50,000 per year in retirement accounts. Suffice to say, we don’t have that much money to play with. So, with regard to the money in question, we could:

  • Put all of it into my business,
  • Put all of it into retirement accounts, or
  • Split it up somehow.

So I’m very curious to hear your sagely input: How do you allocate between retirement savings and investments that you hope will provide increased income?

Renters Insurance: Cost and Tips on Buying

Last time we moved, I made a bonehead mistake: I forgot to buy a new renters insurance policy. We got lucky and had no uninsured losses, but for somebody who spends his time writing and thinking about personal finance topics, you’d think I would know better!

Regardless, the process of shopping for renters insurance is worth discussing.

How much does renters insurance cost?

Short answer: Not much.

The exact cost will naturally depend upon how much coverage you need, whether you’ve had losses in the past, where you live, what type of safety features your residence has, and so on. Our own policy provides coverage for $19,000 of personal property for an annual premium of just $100.

Note: It’s worth shopping around. Some of the quotes we received were more than twice as high for coverage that was no better.

Get the Right Amount (and  Types) of Coverage

Most renters insurance policies have limits on the amount of coverage they’ll provide for specific types of property. For example, a policy might provide $15,000 of coverage, but only cover $1,000 of jewelry. If you need more than that, you’ll have to increase the jewelry coverage specifically rather than just increasing the amount of total coverage.

When you’re shopping for quotes, be sure that you’re comparing apples to apples. The policy that initially looks cheapest may not be the best once you realize you’ll have to add more coverage for jewelry, personal computers, and so on.

Also of note: Most policies don’t cover earthquakes, landslides, or floods. If those are significant risks where you live, you’ll need to purchase separate coverage specifically for the sake of insuring against them.

Where to Shop for Quotes

There are several websites that allow you to enter your information and receive quotes from various companies. I tried two such sites and wouldn’t recommend either of them for two reasons:

  1. The quotes provided are unofficial (meaning that in the end, you need to contact the insurance company directly to get an official quote), and
  2. They give out your contact info to insurance reps with several companies. (Forgive me for not thinking this is a valuable service…)

Instead, I’d shop directly with the insurance companies–State Farm, Allstate, Esurance, and GEICO, would all be good places to start.

Be sure to read your policy.

After you purchase a policy, the insurance company will send you a paper copy in the mail.

Be sure to read it.

If your policy doesn’t cover something that you expected it to, better to find out now rather than later. (Note: I’m not talking about reading the glossy brochure, though you can read that if you want. I’m talking about the boring, legal-looking document that’s printed on pages that look like they came from a Bible.)

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