The illusion of safety, the magic of risk

August 1, 2005

Every investment has risk. Even an FDIC savings account at a bank has some risk. While the risk of the bank going belly up and the government bank insurance program being unable to pay your claim is effectively zero, the risk of having your investment slowly eaten away by inflation is real.

Some investments are undeniably more risky than others – a single biotech company hoping to get FDA approval is far riskier than a government bond. But risk levels are by no means set in stone. Technology stocks are risky, but what if the Nasdaq plummeted to 300 and stocks like eBay traded at 3 times earnings and Microsoft paid a 20% dividend? Would tech stocks be risky at these levels? Tech stocks are not intrinsically risky like a motorcycle. They are risky because they usually trade at prices that are a little too optimistic.

What if everybody decided government bonds were the only safe investment and piled in? With near unlimited demand, bond prices would increase, sending yields down to below 1% – or even zero percent. At that point, would buying a no-interest bond that, at best, will return your original investment back years later be a safe investment? What if there is inflation? Microsoft, which at these hypothetical levels pays out 20% of your investment every year, can raise prices if there is inflation. It is entirely possible – although rather unlikely – that a tech stock can be safer than a government bond.

The issue we’re raising is that investors tend to get something lodged in their head and latch on to it – sometimes to their peril. Making a reasonable assessment of risk is arguably the most important part of investing, closely followed by assumptions of possible returns. In simple terms, how much one can make compared to how much one can lose.

Since risk is such a cornerstone to investing, the investing community has figured out (or so they think) ways to determine how risky something is. Risk with most market traded investments – stocks, bonds, derivatives, even mutual funds – is generally defined as volatility – how much something moves up or down. 

Safe investments are ones that don’t jump around in price – rather, they move like a calm sea. Risky investments are quite volatile, making broad swings even over short periods of time. Standard deviation is a statistical measure of such dispersion and is often used to assess investment risk. At best you’re getting a measure of the chance the price will be very different in the short term.

Of course there are flaws with such risk assessment methodologies, but many use them – including us to some extent. It may be the easiest (but perhaps not the best) way of measuring risk. Such statistical risk assessments are really only slightly more sophisticated than what goes on in an individual’s head. If something seems relatively stable, we think it’s low risk. If the same something delivers great returns, then it’s a fabulous investment – low risk and high return.

Mutual funds are generally rated strictly on risk verses return – how volatile was the fund, and how well has it done? People’s assessment of tech stocks in the late 90s was no different – sure Cisco was riskier than other stocks (it jumped around like crazy), but the upside was so spectacular it created a good risk/reward tradeoff. 

Real estate today is broadly assumed to be a nearly risk-free asset class – only unlike a bank CD, you can routinely make low, double-digit returns. If you calculated the standard deviation on a home (if you could get a frequent market quote on the property), and contrasted this smooth ride to the major gains many homes have made in recent years, it would appear to be the greatest investment of all time – and in the past, from a risk-to-reward point of view, it may very well have been (at least in recent memory).

More money has been lost by investors – top Noble Prize-winning professionals and Joe E*Trades alike – by poor risk assessment based on past volatility. Most major hedge fund blow-ups you read about in the paper were bets that should have worked – and had in fact worked in the past for years if not decades – that suddenly went awry because some historical volatility or relationship changed.

97% of the time you can probably size up the risk of an investment by its fluctuations. But risk is not volatility, which the financial community would consider the notion of a mad heretic. Risk is downside potential. Risk is certainty: how sure can you be that the past will repeat itself, or that your estimate of the future will be accurate? Risk is relative to other options, and is a moving target at all times.

One possible future scenario that could turn some fundamental risk relationships upside down is comparing bonds to stocks. Bonds are clearly safer than stocks, particularly in the short run. The volatility is far lower because the upside is fixed and predictable, and the downside is limited because legally you have more of a claim to a company’s assets with bonds than with stocks. Companies have to pay bond interest or they are in default. Companies are under no obligations to pay stock dividends. But if every baby boomer shifts their non-home assets from stocks to bonds in retirement because bonds are safer, maybe they won’t be.

If stocks get cheap enough (or bonds get dear enough) the safe retirement portfolio could be comprised of stocks alone (maybe even with a large dose of technology stocks!). We are currently nowhere near such an absurd pricing relationship between the two major asset classes, but you still shouldn’t get married to the notion that one strategy is always riskier than another no matter what. If home prices doubled next year across the board and rents remained the same, and the stock market fell 50% (so that the S&P500 had a roughly 4% dividend), not only could it make sense to sell your home, rent, and buy stocks with the extra proceeds, it would be safer – even though stocks are “riskier” than real estate. Maybe the safer we think an investment is the more risky it becomes. Instead of measuring volatility, perhaps an investor’s gut feeling about what’s risky and what’s not, and how much they think they will earn is a better strategy.