I once asked a close relative of mine if he would consider investing alongside myself in my stock market investment portfolio. “Stock market?” he replied, “but there are risks!”. He then went on to invest a large chunk of his fortune in creating his own company (and asked me to co-invest with him 😃). Never mind that my portfolio is composed of the biggest US fortune 500 companies, he felt it less risky to invest in what is essentially a startup. Market risks are poorly understood and usually confused with emotions. So what is Risk? Let me present here some basic concepts of investment risks.
It’s because there are risks that there are returns
A thought experiment
Let us consider a thought experiment, in which an investor has to choose between two possible investments. In investment A, he will get a 2% return after one year with a 100% guarantee. In investment B, there are two possible outcomes:
(i) in one year from now, he makes a 7% return (with 50% chance of happening), or
(ii) in one year from now, he makes a 3% loss (with 50% chance of happening).
Although investment B produces two possible outcomes, we can still compare it to investment A by taking its average (or expected) outcome. And that is a net 2% (= average of (+7%) and (-3%)).
In one case, you make a 100% guaranteed 2% gain. In the other case, although the expected outcome is also 2%, you can have a bigger upside, but you could also end up losing money! So investment A is risk-free, while investment B is risky.
So what is Risk?
We can define the risk of an investment by the dispersion of possible outcomes around the average, whereas the expected return is the average of possible outcomes. In investment A, the expected return is 2%, with 100% certainty (no dispersion in outcomes, i.e. no risk). In investment B, the dispersion (or risk) is +/- 5% around the expected return of 2%.
Which investment would you personally prefer?
- If you prefer investment A, you are a risk averse investor. You hate the 5% downside more than you love the 5% upside, so you chose the safe 2% investment.
- If you prefer investment B, you are a risk seeking investor. You love the 5% upside more than you hate the 5% downside, so you prefer B in order to get a chance at this possible 7%.
- And if you value A or B equally, you are a risk neutral investor. Downside or upside, it doesn’t matter, in average they both return 2%.
There is no right or wrong answer here, and it boils down to personal preference. But it is a well established fact that, for the majority of investors, the clear preference is A. Investors are risk averse! And because of this bias against the downside, the market tends to trade investment B at a lower price than investment A.
That is to say, if investment A’s value is 102$ in one year, today it is worth 100$. And if investment B is worth either 107$ or 97$ in one year, then it would appear to be worth 100$ today. But at this price, the majority of investors would chose investment A instead, so in order to attract any demand, investment B must be traded at a lower price than investment A.
So for the argument’s sake, say that investment B is worth 98$ today. Where both investments would, in average, be worth 102$ in a year, the risky one is worth less than the safe one. This 2$ difference in value today (98$ vs. 100$) is completely attributed to investors bias against possible downside.
But now, view it this way. With investment A, you pay 100$ today and get 102$ in one year. With investment B, you pay 98$ today and get in average 102$ in one year. So, in average, you get a higher return (about 4%) from the risky investment. The difference in return (4% – 2% = 2%) is called the risk premium: extra expected return for holding extra risk.
In average over the long run
I used the words “in average” many times, but what exactly did I mean by that? If you hold investment B, and get the negative outcome after one year (50% chance), you will be sitting on a loss, no matter the expected outcome of 4%.
But the key is to realize that, if you repeat investment B again and again, you ultimately will get an net annual return, over the long term, close to the theoretical 4%. It’s like tossing coins: you can’t keep getting tails all the time. “In average” means that, provided investment B can be repeated many times over the long term with the same possible outcomes, the average is what you ultimately get in the long run.
But there is more to Investment Risk.
Two main types of risk
Market risk: the risk you actually want to hold
In Investment B, you can get a negative outcome once, maybe a few consecutive times, but assuming that you can keep investing in B over and over again, eventually you will get some positive outcomes, recover from your unlucky slump, and over the long term converge towards a 4% annual rate of return.
And that’s also true in real life. Markets go down, then recover and ultimately resume the long term trend, which is overall positive. A slump, no matter how serious it looks, is a temporary thing. Bad economic news and higher risk aversion temporarily translate into lower prices, but eventually the economy recovers, fear level recedes to normal, and the market goes up again. We usually call market risk these embedded, normal features of the market, consisting in recurring high and lows.
Over the long term, market risk is rewarded by a higher risk premium, by the mechanism described in the previous section. This kind of risk is actually your friend!
Systemic risk: the risk you absolutely do not want
But something was not represented in our thought experiment. Every investment has a small chance of simply disappearing from the face of the Earth. The underlying business just goes bankrupt! And from this, there is (normally) no recovery. Your money is just gone! The major example is Lehman Brothers – a century old company who just ceased to exist following major losses in 2008. If you had invested your fortune in Lehman, you have lost all your money.
A bit less extreme, there are some companies whose business takes a big dive, without actually becoming bankrupt, but then never recover from there (or at least not within a decent time frame). You take the loss, but never recover from it. A good example of this is Citigroup. Adjusted for splits as per today’s valuation, Citigroup peaked in 2007 near $550 per share, and collapsed to $15 per share within 15 months. It has recovered somewhat since then, but at today’s level (70$ per share) it is still very far below it’s former level. Although not as extreme as the Lehman example, if you had invested in Citi before the crash, you lost a significant amount of your investment, and ten years later there are still no signs that you will ever get it back.
Let’s call it systemic risk. This is the risk you do not want to hold in your portfolio! It can potentially yield major losses from which you can’t recover.
The Geek Note: it is actually called “idiosyncratic risk” by practitioners, whereas “systemic risk” is usually referring to the risk that the whole economic system collapses. Here I view it as systemic risk, when the system consist of one single company. The term is more self explanatory than idiosyncratic risk, a much more barbaric term.
But you can diversify!
The good news is, there is a way to significantly reduce this undesirable systemic risk: by holding a highly diversified portfolio composed of many, many stocks. For instance, if you hold a portfolio composed of the 500 largest US market capitalization companies, what is the likelihood that all these 500 companies go all bankrupt at once? We are talking about all the big names: Google, Facebook, Microsoft, Coca Cola, Johnson and Johnson, Colgate, Wells Fargo, Mastercard, Pfeizer, etc… For all these companies to go bankrupt at once, you would require a major disaster such as a nuclear war. The world would be fucked up anyway! Barring that, it is very unlikely to happen.
What you could observe, though, is that one, or a few, of these companies to incur a systemic loss. It happened in 2008. But then, each of these 500 companies represents about 0.2% of your portfolio. If 10 of them disappear, it’s only 2% of your investment! It is no longer all or nothing, like you would have had if you had invested 100% of your fortune in Lehman back in 2008.
Diversification diluted the pain away to a minimum.
A note on other investment types
I heavily borrowed (implicitly) my examples from the stock markets. But the same holds equally well for other investment types.
In the bond markets, for instance, the price of a corporate bond, delivering X% interest over a period, typically trades at a cheaper price than an equivalent US government bond, delivering X% over the same period. Why? Because the company issuing the bond could go bankrupt and cease payment. This extra risk, called credit risk, is responsible for this mismatch in market price. Similarly, because you purchase the corporate bond at a lower market price, the bond ends up yielding a higher return over the course of its life, earning you an extra “credit risk premium”.
It is a general feature of the markets that market participants discount the price of higher risk investments, which thus end up yielding more, in average, over the long term.
Back to my relative
So now let’s revisit my relative’s proposition. He preferred to walk away from an investment in a diversified basket in US large capitalization companies, and invest instead in a single micro capitalization business.
I am not here to criticize this decision. He prefers the Entrepreneur way to financial freedom, and it is a fairly respectable choice. And in fact I agreed to co-invest myself with him, because I trust his abilities as a manager – although, true to my diversification principles, my investment with him amounts to maybe 4% of my total portfolio.
But when it comes to justifying his decision (“stock market is risky”), I am going to argue that it was fairly irrational, and coming from deep misconceptions about investing and investment risks. I am going to argue that, in fact, he is taking much bigger risks with his company. To name the largest:
Big systemic risk
Small businesses are about meeting both ends. Big payments are coming up. Customers paying in arrears. Money coming out, money coming in. But if you don’t have the cash immediately available to meet deadlines, you are insolvent, game over! So it is always about a tight management of treasury (the so-called “working capital”). You’re always only three months away from being bankrupt, potentially.
Poor diversification
Even if the chance of being bankrupt amounts to, say, 10% chances over the course of 7 years, it is still 10% chance of losing 100% of your money. This doesn’t occur in a diversified portfolio of investments.
Also, his business depends on a small handful of large customers. Not sure about his suppliers (I think it is OK) but in general, a startup business may be dependent on a handful of suppliers, too. One large customer decides to change vendors, the revenues will take a hit. One large supplier decides to raise prices, the profit margin will take a hit. This is lack of diversification too. Big outcomes in the hands of a small set of external players.
Conclusion: where this misconception is coming from
It is coming from a few things.
- To a non-professional, the stock market looks like a series of random numbers on which there is no control. But they forget that these numbers are tied to real life companies, whose growth is powered by a growing economy
- Also, most people end up losing money on the stock market, and I am planning to write on this topic. But this actually stems from mis-management! If someone looks for the long term story of stock and bond markets, it actually is a success story!
But a last reason I see is because of a deep misunderstanding of the investment risks: those which are desirable, and those which aren’t. And it also ignores that we can measure, mitigate and manage these risks.
I hope the present post has clarified the last point.
Yours,
