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How Do You Define Risk?

The finance community and financial services industry most commonly define “risk” as variability of annual returns.

I’ve never much liked that definition.

For example, in my retirement portfolio, I don’t care in the slightest what happens on a year-to-year basis. I’m much more concerned with what my annualized return will look like over the next 30 years. So why on earth would I measure risk as the variability of annual returns?

When I first read Jeremy Siegel’s Stocks for the Long Run, I enjoyed it tremendously. Rather than looking at variability of annual returns, he looked at variability of inflation-adjusted returns over various periods, thereby allowing an investor to glean some information as to how predictable stock and bond returns tend to be over the applicable time horizon. Perfect!

[Side note: What he found was that over periods of 30 years or more, bond returns are actually less predictable than stock returns. The conclusion, therefore, is that for anybody more concerned with 30-year periods than 1-year periods, stocks are safer than bonds.

Many people have pointed out that Siegel’s analysis only looks at the U.S. and only over a period of explosive economic growth. That’s true. So it’s possible that his conclusions are invalid. But at least he was measuring the right thing.]

Risk is personal.

While Siegel’s definition of risk is perfect for me, it might not be the best measure of risk for you.

For example, I might say that, for an investor with a 30-year time horizon, an investment is safe if it’s likely to earn a predictable return over that 30-year period.

But what if the investor in question is the type who’s likely to be scared by a decline in value at any point over those 30 years, even if the return over the entire period is fairly predictable? Well, then perhaps my “safe” investment isn’t safe for that investor after all.

What scares you?

I think most investors would do well to spend some time thinking about what it is that really scares or upsets them when they think about money.

Does it bother you every time you see your portfolio value go down? Then perhaps you should measure “risk” as probability of loss. (And for the period in question, use the frequency with which you check your portfolio.)

Are you scared of outliving your money? Then perhaps you should consider “risk” to be the variability of returns over periods equal in length to your current life expectancy.

Does it frustrate you to no end when everybody else seems to be making money, but your portfolio is lagging? Then perhaps some version of tracking error would be a good measure of “risk” for you.

Until you know precisely what it is that you’re trying to avoid, there’s no way to know what’s safe and what’s risky. (And you can’t rely on other people’s statements on the matter, because their definition could be different from your own.)

Risks Involved in Buying Bonds

There’s a poker saying that if you can’t spot the sucker at the table, you must be the sucker. The investing corollary:

If you can’t spot the risk in an investment, you don’t understand the investment.

Bonds are generally assumed to be a low-risk investment. And in many (though not all) cases, that’s true. But they’re never risk-free.

For example, there are three ways you can lose money by investing in bonds. (For the moment, we’ll ignore risks such as reinvestment risk that, while they can cause your return to be lower than expected, do not cause a loss of capital.)

Default Risk (a.k.a. Credit Risk)

The first and most obvious risk involved in a bond transaction is default risk: the risk that the borrower will go belly-up and be unable to make the promised payments.

  • Junk bonds have high default risk.
  • Corporate bonds have moderate default risk.
  • Municipal bonds (usually) have low default risk.
  • Treasury bonds are assumed to be free of default risk.

In every case except for Treasury bonds, buying a bond fund or ETF rather than individual bonds can help you reduce default risk via diversification.

Inflation Risk

Unexpected inflation is a significant risk when your interest payments are held constant.

For example, had you bought a 10-year Treasury bond at the end of 1971, you would have received a nominal return of 5.9% over the life of the bond. Unfortunately for you, inflation over your 10-year holding period was an annualized 8.7%. Ouch.

The longer the term of the bond, the greater the threat of inflation risk. So one of the best ways to minimize inflation risk is to own short-term bonds.

A second way to protect yourself from inflation risk is to buy Treasury Inflation-Protected Securities (TIPS). These bonds promise a specific after-inflation return rather than a specific nominal return.

Interest Rate Risk

When interest rates go up, bond prices go down (and vice versa).

For example, imagine that you buy a 10-year Treasury bond paying 3% interest. Now, imagine that one year later, the interest rate on new Treasury bonds has gone up to 4%. If you wanted to sell your 3% bond, who would buy it? Nobody.

…unless they were able to buy it at a discount–specifically, a discount large enough for them to earn an effective 4% rate.

Two notes about interest rate risk:

  1. The longer the maturity of the bond, the more its market price will fluctuate as a function of current interest rates. End result: If you have a short time frame, a 30-year bond (even a US Treasury bond) is not a safe investment.
  2. While TIPS are not subject to inflation risk, they are subject to interest rate risk. This means that you can lose money by purchasing TIPS if you have to sell them prior to maturity and market interest rates are higher than they were at the time of your purchase.

Risk, Cost of Capital, and Expected Return

“The single most reliable indicator of fraud is the promise of high return with low risk.” — William Bernstein in The Investor’s Manifesto.

It’s no secret that risk and return are related.  But how should we measure risk? For decades, the finance community has been equating risk with volatility (often calculated and presented in the form of standard deviation).

Others, however, have argued that volatility isn’t necessarily the best measure of risk. They argue that cost of capital is a better measure of risk–a primary reason being cost of capital’s direct link to expected return.

Cost of Capital: Bond Returns

To illustrate the link between cost of capital and expected returns, consider the bond market. The interest rate a company offers on its bonds is both the company’s cost of capital and the bond buyers’ expected return. Simple, right?

And the worse a company’s credit rating, the higher the interest rate it will have to offer on a series of bonds in order to get investors to buy them. End result:

higher risk = higher cost of capital = higher expected returns.

Cost of Capital: Stocks vs. Bonds

The same relationship exists when comparing stock returns to bond returns. Capital raised by issuing bonds comes at a lower cost to the company than capital raised by issuing stock. Why? Because investors demand greater expected returns from stocks than they do from bonds in order to compensate for the uncertainty of payoff.

higher risk = higher cost of capital = higher expected returns.

Cost of Capital: Small-Cap and Value Stocks

The link between risk, cost of capital, and expected returns also explains why small-cap stocks and value stocks have historically earned higher returns than their large-cap and growth counterparts.

Start-up companies involve more risk than large, well-established companies. So it makes sense that a small-cap company has to offer investors a proportionally greater share in the company’s profits in order to raise a given amount of capital.

higher risk = higher cost of capital = higher expected returns.

The same thing occurs with value companies as compared to growth companies. If the expected returns were the same, why would you ever invest in a poorly-run company in a declining industry? You wouldn’t. And neither would anybody else. To attract capital, value companies have to offer more attractive expected returns than growth companies.

higher risk = higher cost of capital = higher expected returns.

Remember, we’re talking about expected return.

All of this is not to say that small-cap stocks will earn more than large-cap stocks, or that stocks will earn more than bonds. Over any given period, something other than the “expected” may certainly occur.

Uncompensated Risk is for Suckers

We’re about to dig into something a bit more technical than we usually discuss on this blog, but I promise it’s worth it. Understanding the concept can have a direct impact on your investment results.

Risk can be broadly divided into two categories:

  1. Diversifiable risk, and
  2. Undiversifiable risk (also known as systematic risk).

In order to explain, let’s imagine that you’re considering buying stock in a given company.

Diversifiable risk is the risk resulting from the possibility that the company will fail — or at least, fail to earn a satisfactory level of profits.

Undiversifiable risk is the risk that results from the possibility that the stock market as a whole can decline in value over any given period of time.

The reason for the name “diversifiable risk” is that, if you own enough companies — that is, if you’re sufficiently diversified — then diversifiable risk is mostly eliminated. You’re no longer exposed to any significant risk resulting from the failure of one particular company.

In short, “diversifiable risk” = “risk that can be eliminated via diversification.”

On the other hand, no matter how many companies you own (except for “zero,” that is), you’re exposed to the possibility that the entire stock market will decline in value. Undiversifiable risk cannot be eliminated via diversification, hence the name.

Why the distinction matters

If you’ve done much reading about investing, you know that greater risk leads to greater expected return.

The reasoning is that, when an investment’s returns are volatile, it becomes less desirable to investors relative to investments with more predictable returns.  This lower demand results in a lower market price for the investment, thereby resulting in a greater expected return.

Here’s the catch that many investors miss: When people talk about risk being rewarded with return, they’re only talking about nondiversifiable risk.

Why? Because if risk can be eliminated through something as simple as diversification, it’s not all that undesirable. As a result, it neither decreases demand nor increases expected return.

How you can profit with this knowledge

By understanding that the market only rewards risk that can’t be eliminated by diversification, you can set yourself up to maximize your expected return relative to your risk. How?

By diversifying like crazy. After selecting the asset classes in which you want to invest, diversify as broadly as possible within those investment classes. In other words, buy index funds.

Or to look at it from the opposite perspective: investing in individual securities within an investment class (ie, picking stocks) increases your risk without increasing your expected return. Sounds like a poor bet to me.

Investing and the Worst-Case Scenario

As you probably know if you’ve been following this blog for very long, I tend to recommend rather high equity allocations for those of us who still have multiple decades to go until retirement.

My own retirement portfolio is 90% in stock index funds, and as I’ve discussed before, I don’t see anything wrong with being 100% in equities if you’re still quite young and have a particularly high tolerance for volatility.

The fear

You’ll often hear that being so heavily invested in equities is dangerous. People say things like, “What if stocks go to zero? You could lose all your money if you aren’t diversified.”

That’s true. And it’s an understandable fear. After all, we’ve seen several high-profile occasions on which (individual) stocks went to zero over the last decade.

However, the way I see it, there are two major problems with worrying about a similar thing happening to an internationally-diversified portfolio of stock index funds.

First, it’s extremely unlikely that all (or even most) of the businesses in the world economy will become valueless.

Second, if that were to happen, bonds would offer you absolutely no protection.

Bonds won’t save you.

For the entire world stock market to go to zero (or for that matter, to earn any substantial negative return) over, say, a 30 or 40-year period, the businesses that make up our global economy would have had to collectively become unprofitable. This, of course, would have several ramifications:

  • You would lose your job.
  • So would every other person living in a country with a developed economy.
  • The world economy as we know it would have completely collapsed. And we would each be reliant on our abilities to produce physical goods to sustain ourselves.

Note that in such a scenario, having had your IRA and 401k go to zero would be the least of your concerns. Of course, there are things you can do to prepare yourself for such a situation. For example:

  1. Learn to grow your own food, and
  2. Buy a gun.

As you may have guessed, I’ve done neither of the above–although I suppose my wife is currently looking into what edible plants can be grown indoors. The point, though, is that “own bonds” is not on the list.

In an environment in which business are no longer making any profits, corporate bonds would be just as worthless as common stocks. And government bonds would almost certainly be as well. (If nobody is making any money, how would the government have any tax revenue?)

So is there any reason to own bonds?

In short: Yes. There certainly are some valid reasons to include bonds in your portfolio. (More on this tomorrow.) [Update: See follow-up post here.] However, protecting yourself from a doomsday/economic collapse scenario is not one of those reasons.

Manager Risk? No thanks.

The state of Oregon is suing Oppenheimer Funds for understating the risk it took while managing a bond fund in the state’s college savings plan. From the Wall Street Journal:

Oregon charges that Oppenheimer Core Bond fund, which was in the state’s 529-plan options billed as “conservative,” became significantly more risky starting in late 2007 or early 2008. The fund lost 36% of its value in 2008, but its benchmark index, the Barclays Capital Aggregate Bond Index, rose 5.2%.

“The Core Bond Fund was no longer a plain bond fund,” the complaint says. “It had become a hedge-fund like investment fund that took extreme risks.”

When you invest in an actively-managed fund, there is a chance that the manager will make some excellent decisions (or get lucky), and thereby substantially outperform the relevant index/benchmark.

On the other hand, there is also a chance that he’ll get horribly unlucky or make a series of bonehead mistakes, thereby causing the fund to severely underperform.

In other words, active management makes your returns less predictable. It adds an additional level of risk.

The way I see it, taking on additional risk only makes sense if you’re being compensated with an increase in expected return. Unfortunately, as we know, choosing active funds over passive funds does not increase your expected return.

[Quick note: I say “expected return” rather than simply “return” because the very nature of taking on risk means that returns are not possible to predict precisely. Example: Stocks have a greater expected return than bonds, but there’s no telling ahead of time whether stock returns will be greater or less than bond returns in any particular period.]

Many investors gain comfort from knowing that a professional is managing their money. Odd as it may sound, I gain comfort from knowing that nobody is managing mine.* 🙂

*Yeah, OK. I guess I’m managing it in the sense of choosing an asset allocation, selecting specific index funds, and so on. But you get the idea.

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