Monday, 27 June 2011

Investing Risk: What is there to lose?

For most investors, risk means the chance of loss of part or all of their investment. In some imaginary world, we could all become rich with no risk in our investments. But, as the expression goes, "no risk, no reward". In order to reach future goals, whether it be retirement, education, a house, most people need to do more than merely save. They need to have their savings grow through investment. The ability to understand and control investing risk, taking appropriate risks in the context of those goals and one's personal circumstances, is essential for investing success. To that end, we break down investing risk into its main components and explore ways to counter each one by interpreting our deliberately ambiguous title What is there to lose? in three ways.

1) What do I have to lose?
The significance of risk depends in part on the impact on the investor. Circumstances unique to the investor heavily affect the decision on how to deal with the risks - to accept, mitigate or transfer the risk to someone else (for a price, of course).
  • Time Horizon - How long before you will, or might, need the money strongly influences whether certain types of investment and their inherent risk characteristics are acceptable at all, and what counter-measures make sense. Many people will have multiple time horizons, for example, retirement and a house or a legacy. Retirement itself will involve spending year by year, from the immediate to the, hopefully(!), far distant. Some of the external risks we discuss below can effectively be dealt with if a person has a long term horizon and can simply ride out what may be very severe but passing non-permanent losses.
  • Wealth - The richer you are, the more you can afford to take some losses or wait out short-term market volatility. A $10,000 or even a 10%, loss for a multi-millionaire hurts him/her a lot less than the same loss for an average wage earner.
2) How can various types of investments lose?
Bad things can happen in the financial world. Some happen steadily and predictably every year, others suddenly and violently. Some are quite visible, others much less so. Some cause irreparable damage, others only temporarily. Some are unavoidable, others resulting from investor panic reaction.
  • Volatility - Daily, weekly and monthly price movements downwards can look worrisome on account statements e.g. as we write, the TSX is in a "correction" - down more than 10% from the previous high. Most people do not panic and sell in reaction to such a decline, but doing so will lock in losses if they end up buying back in at higher level once the correction ends. As David Parkinson tells us in Correction: Signs of doom have been greatly exaggerated in the Globe and Mail, corrections happen more years than not and the recovery is normally quick. Counter-measures: Short-term - buy put options on your holdings, which perfectly counter-balances any decline, but why bother if you can simply do the following. Long-term - continue to hold. Diversification - holding many types of asset classes in a portfolio will dampen swings. The S&P 500 index is down much less than the TSX and bonds are up so a portfolio with all three would not be down much.
  • Default / No Repayment - The chance that you may not get your money back despite explicit promises to do so by companies and governments applies mainly to fixed income investments. Such promises are only as good as the organization making them and times can change. If the promising organization runs into financial trouble, it may not be able or willing to repay all or part of the principal. Some people think US Treasury Bonds are not as safe as they have been up to now. Twenty years ago, the Canadian government's ability to pay prompted derisory descriptions of it as the northern peso but now Canada's finances are among the strongest in the world. In the case of common equity, there is not even a promise to repay, only residual rights to whatever is left after all other claims have been paid off (mainly bondholders, taxes, employees). Sometimes governments simply expropriate companies for political motives and do not offer fair compensation. Counter-measures: Diversification - multiple holdings in a particular asset class spreads the risk and lessens the impact of any one holding going bad. ETFs and mutual funds offer this quality to investors. Bond ladders can help somewhat but it takes a sizable portfolio with many holdings to reduce the impact of any single holding enough. Due diligence - Credit rating agencies publish their opinion on the likelihood of fixed income corporate and government securities being able to meet their promises as we discussed in Seeking Safety. Credit raters do get things wrong. For individual securities, the investor would be advised to develop skills in reading financial statements and keep abreast of developments in the subject organization to get his/her own idea of evolving safety.
  • Business Cycles - Economies and business go through constant though irregular cycles of expansion and booming times followed by recessions and retrenchment. Investments respond and follow suit, or more exactly, anticipate such cycles, which can stay for several years in upward or downward movement. Counter-measures: Diversification - Holdings across different sectors and countries even out and dampen the effects since business cycles are not in perfect sync or severity across such boundaries. Continue to hold - As with shorter term volatility, stay invested and the drop will be recovered, especially when one holds broad-based passive funds that more or less cover the whole market. Trying to time the cycles - selling before the drop to buy in again at the bottom - is so difficult, most professionals don't try it as the consensus is that you cannot win consistently.
  • Asset Crashes and Financial Crises - These are severe negative events for investors. They frighten by their speed and sudden onset and depress by their duration, whose after-effects can extend to a decade or more. In the case of the 2008 financial crisis, we are still living with the consequences three years later. The systemic and structural defects await to be fixed and government debt loads from bailouts or the property crash remain extremely high or are climbing to unsustainable levels. As we saw when we reviewed the situation in Tech Stocks Revisited, tech stocks still had not recovered as a whole ten years after the Internet mania. Contrary to what some hope or mistakenly believe, such crashes are not once-in-a-hundred-years occurrences - more like every ten years since the 1970s. Counter-measures: Diversification - That includes holding a certain amount of cash and the safest government T-bills available, which these days for a Canadian means those issued by the federal government. See our post The 2008 Crash - Case Study in Diversification on what worked during the most recent episode of an extreme market downturn. Though the cash and short-term government debt should always be in a portfolio, the next crash will no doubt be somewhat different such that another asset mix will hold up better than what worked in the past. Thus, holding a variety of asset classes adds protection. Rebalance - When there are drastic drops in some or many asset classes, the ultra-safe ones will hold their value as the 2008 experience demonstrates. That is the time to re-establish the portfolio proportions according to the intended asset allocation.
  • Unexpected Inflation - The current expected medium to long term inflation of around 2%, which is the Bank of Canada's explicit target rate for the country, is already incorporated into rates. If inflation were to jump upwards to 5%, whether due to sustained increases in commodity prices, as currently seems to be the main source of such concerns, or something else, the value of fixed income holdings in particular would fall drastically. Equities would too, at least for a time while companies adjusted their pricing to recover lost profits. Counter-measures: Real Return Bonds - These federal government bonds (and some provinces offer them too) continuously ratchet up the interest paid and the principal value in line with CPI. No need to guess about future CPI, though they will pay a bit less as a result. Equities - Though they suffer in the short term, the ability of companies to increase prices to maintain profit margins means they will cope with unexpected inflation in the longer term.
  • Fees & Agent Costs - The management fees charged by mutual funds or ETFs and the salaries/bonuses paid to company management & employees reduce the returns going to the investor. The risk is that such costs will be excessive - that the profits go to these agents instead of the investor. Fees are too often hidden or difficult to see. A 2% annual fee seems small, which is the reason most investors don't get alarmed. But such seemingly small annual fees can add up significantly over the years as Independent Investor shows. The effect after 20 years can reduce a portfolio's value as much as the most severe market crash. It is just in slow motion not fast. Counter-measures: Shop-around for low fees - There are low cost funds around and efficient companies. Do some research. This blog attempts to contribute to this process by taking fees into account when assessing ETFs or other investments. The playing field is not level so it can really pay off to take steps to keep fees low. Very few high fee funds outperform and justify their high fees. High fees mean a high risk of significant portfolio loss for the long term investor.
  • Required Return - The return expected or demanded by investors as a whole, i.e. the market, varies up or down. The same company's shares or bonds with the same continuing business outlook may be valued less and fall if the market demands a higher return. This may happen independently of both inflation and official Bank of Canada interest rates. The cause may be higher risk aversion or risk perception but the effect is that prices drop. explains this factor, which he calls Interest Rate Risk, in detail. Counter-measures: Floating rate debt, Rate reset preferred shares - These securities include automatic or investor-choice adjustment to higher rates as market rates change. Short-term debt - The frequent rolling over of such debt allows the investments to be reinvested at higher rates as they change, though that also means the possibility of going down too and the rates will be lower than longer term options. Equities with pricing power - When required returns go up, companies with pricing power can increase prices to offset their rising financing costs and boost returns.
  • Foreign Currency Shifts - When the Canadian dollar (CAD) is rising against the US dollar or other currencies, the net return on foreign investments after translation back into Canadian dollars is reduced. A strong CAD may even turn a foreign profit into a loss. Counter-measures: Hedge - Many ETFs and mutual funds invested in foreign securities takes measures to eliminate the effect of currency movements. Recently, we took a close look at two such ETFs that track the US S&P 500 Index. Retail Investor's How to Hedge Foreign Currency describes several other methods an investor with the time and interest can use to do so him/herself. We discussed the pros and cons of hedging in To Hedge or Not to Hedge.
3) Why should I bother worrying about it?
The carefree and careless attitude typified by this last form of the question is a sure-fire way to turn the above uncertain risks into certain losses. One cannot be fatalistic. Counter-measures: Plan and review - Set up a portfolio and an investment plan adapted to life goals, as we wrote about in the very first posts of this blog here, here and here. Follow that with a regular but not too-frequent review (otherwise it becomes obsessive and creates un-necessary worry in the day-to-day noise), such as we discussed in Annual Investment Review. The philosophy to adopt is to seek continual improvement. Scenarios and Too-small-to-fail - Taking a look at market history gives an idea of the possible extreme downside results that various asset classes and securities might produce. Consideration of the impact of the ultimate downside where an investment is wiped out helps inject a proper degree of caution. No single investment should be large enough to cause catastrophe for the investor.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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