How to Ensure You Don’t Lose Money Part 3

money

In today’s market (April 2013) we’ve got a major problem with most of the investments out there, something most people aren’t accounting for in their calculations, but they should, inflation.  Lots of people will sit in a cash position because they are uncertain where to invest, what the market will do, etc.  What does this really mean?  They are losing 2-3%/yr.

If you don’t want to lose money you have to beat inflation.

Most people, most of the time don’t need to contend with hyper-inflation and frankly, hyperinflation is a tough thing to cope with so we won’t address that here except to say that real assets provided you can hold them are the only real hedge there.  But we all deal with the threats of inflation, which is historically in most of the western world somewhere around 3% give or take.  For those who aren’t familiar inflation is the gradual decrease in purchasing power of each of your dollars due to increases in prices.

Today, bonds, GICs, and savings accounts actually provide a negative return when measured against inflation (banks are advertising 2%/yr. as though it is something special).  In other words you’re losing money (albeit not a lot) even as your money sits in a savings account.  To be clear, you still have the same number of dollars you just can’t buy as much with them, which in the short term doesn’t seem very substantial but it compounds and adds up with time.

So, what are your options?  If you can get a fixed income investment such as a bond, or a debenture, or a loan on a mortgage, which when adjusted for real risk pays more than the value of inflation you’re fine.  Probably the most obvious example of how you can do this is with whole life insurance, which will typically beat inflation and has an array of other benefits, not to mention being about as close to risk free as you can get.  But what about if you can’t easily get cashflow greater than inflation, particularly when you account for risk?

Some investments are essentially inflation adjusting.

There are some investments that are essentially inflation adjusting, this is an advantage of equities and potentially commodities.  Keep in mind these won’t guarantee you won’t take a loss, you need to apply the other strategies we’ve discussed as well, but inflation is accounted in their value.  Here’s how it works, let’s consider property.  If you buy a house (or purchase a fund that buys houses such as units in a REIT) inflation more or less refers to the amount of money in circulation relative to the productive capacity and as people make more money they also spend more money, this is what causes the prices to go up.  Now, if you’d purchased a bond or GICs or mortgage the value will remain the same as the face value.  In other words a GIC purchased today worth $10 000 will always be worth $10 000 at the time of maturity.  But a house will tend to vary in value with the rate of inflation, if inflation goes up so will house prices.  The same is generally true of rents.  That’s not to say that prices and rents are driven by inflation, they aren’t, those markets are much more complex, what it means is inflation will be accounted for so it at least isn’t likely to cost you money.

Where do you think the money goes when the prices rise?

An easy way to understand these dynamics is when the prices rise who gets the extra money?  The people you are buying the real goods and services from.  Think of it this way, you are buying apples for your family, today the prices go up due to inflation so now you’re paying more for apples, but notice you’re buying those apples from someone who now has more money as a result.  (They don’t necessarily have more profit because their expenses might have gone up too but they have inflation adjusted revenue).  In other words if you want to avoid the negative impact of inflation you need to be selling or owning real goods and services.

The class of investments that does this is essentially equities, in other words, companies and real estate where you own the actual asset and not an instrument related to the asset such as a mortgage.  This is because they are real goods and services or involve the supply of real goods and services.  In other words avoid investments with a fixed face value at the time of maturity if they aren’t paying more than the rate of inflation.

​Commodities can be a hedge against inflation.

You might have heard gold is a good hedge against inflation.  Generally, I don’t recommend gold or other commodities but the truth is gold is a real good, likewise for oil, silver, etc. so provided you’re buying it for a fair price over the long term it will protect you against inflation, though many would argue you’re much better off purchasing stable funds of gold mining companies it really depends on the circumstances and your investment goals.  To keep it simple, stick with equities for the majority of your portfolio or fixed income investments paying higher than the rate of inflation.

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How to Ensure You Don’t Lose Money Part 2

Money

We’ve examined how the markets function in cycles and now we’re going to look at how time plays a role in risk.  The reality for anyone investing money is they eventually plan to take it out of investments and use it, after all, what’s the point otherwise?  The question is when?

Here’s the risk, the market moves in cycles varying from boom to bust to recovery, to a sideways market and then another boom, at least as a general rule (it’s not 100% accurate but for our purposes it is close enough).  What if you needed the money, say to get married or for your child’s education in March 2009 or January 1932 just after a major stock market collapse?  You’d likely be forced to either cash out at a major loss or not spend the money as you’d planned, neither is a pleasant prospect for your family’s wealth or children’s education.  So how do you avoid this?

If you want to avoid losing money you need the freedom to choose when to sell.

Given time markets as a whole (not to be confused with individual holdings such as individual stocks or properties) tend to recover in price.  People know this about property almost intrinsically and it’s what stock brokers and financial advisors will often tell you “you’re in this for the long haul” when things are going down.  There’s some definite truth to it though, the key is you need to plan your investments and spending so you can wait until the value has increased in order to sell.

How does this work?  Well if the market is really high and you’re going to be needing the money in the near to mid future, sell part or all of the investment, in other words always make sure you’ve got cash around to cover your short to mid-term needs, the last thing you want is to be selling your investments in a down market because you lost your job.

If you have upcoming cash requirements such as retirement, paying for a child’s education, etc. reallocate some of your investments into investments with short term price stability such as short term bonds or GICs to ensure you aren’t going to lose the money when you exit the investment.  Note, you don’t need to do this for all your money, just enough to cover the needs.

Enter an investment with the expectation of holding if it drops in the short term.

Your expectations and planning play a big role here and applies to buying a house as well as buying equities.  Enter the investment with the thought “if this goes down I’m going to make other arrangements to ensure I don’t have to sell until it recovers”.  A lot of people lose money say by buying  house then need to relocate for work and have to sell when the market is down, often paying mortgage payout penalties in addition to realtor fees and taking a loss on the investment itself.  What would have been much more prudent is to have been prepared to rent the house out while waiting for the market to recover.  Of course the decision isn’t so simple if you’re caught in that situation, but if you’d planned that way from the beginning you’ll generally be ok.  Consider if you’d purchase counter cyclically for below market value then you’re unlikely to find yourself in a position where you’re taking a loss to begin with, but at least if you do and you’ve planned on being able to hold you’ll be better off.

This comes down to the last consideration to protect yourself, which is to have at least some of your portfolio in investments providing cashflow (either dividends or interest).  Consider for example if you purchased the stock of a company or fund and the price goes down.  The market will rise and fall but if the stock or fund you purchased pays dividends then at least you’ve got cashflow to help you weather the storm.  Likewise for real estate, if you’ve got rental cashflow it makes holding much easier than if you have negative cashflow.

One of the biggest keys to not losing money is being able to hold until you have recovered your initial investment or have made a profit.

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How to Ensure You Don’t Lose Money Part 1

Losing Money

This and the following two posts continue and build on the subject of how we decrease risk while increasing return except that in this case you don’t necessarily increase return, you merely decrease risk, that is to say you minimize the chances of losing money.

We’ll start with what I believe is the most important factor in not losing money, at least not losing money in an absolute sense, though it’s only one piece of the puzzle in a relative sense.

Ask yourself “if I wanted to ensure I could sell what I bought for at least as much if not more than what I bought it for, what would be the most important factor I could consider?”

Buy something that will increase in value.

It sounds fairly obvious.  What’s the chance you’ll lose money buying a car?  Pretty high, why?  Because it tends to lose value with time, the same is true of cash, it tends to lose value with time.  What about buying an option, what’s the chance you’ll lose money?  Again, relatively high only because time is working against you, which means the longer you hold the more likely you are to lose money.  There are investments where time works with you and investments where time works against you, if you want to decrease the chances of losing money the solution is to buy things where time works with you by increasing the value.  

What are some examples of this?

  • Rare art – because it becomes increasingly rare with time it tends to increase in value with time
  • Real estate – again because there is a limited supply of it the value tends to increase with time
  • Consistent undervalued companies – notice we’re going back to this point about buying for below what something is worth, in many cases when you buy something for less than what it’s worth it will increase in value, at least for a time, the question is for how long?

What do you need to know about something in order to determine whether it will increase in value?  You need to:

Understand how time affects value in a given investment.

For example, patents might increase in value for a time but they also expire at which point their value expires as well.  The same is often true for royalty rights, books, movies, music, etc. tend to sell at a peak level for a time then decrease in value as sales drop off and then copyrights expire.  Bonds will never exceed their face value at maturity so time affects them by getting closer and closer to the face value (assuming they are going to actually pay out).  By contrast a market fund tends to increase in value with time because the market as a whole tends to grow due to increases in technology, etc.

This brings us to a huge advantage of private investing in certain areas.  What’s the number 1 way to ensure an investment increases in value?

Increase the value of the thing you’re investing in.

This is why people who want to get really exceptional returns generally need to control or at least have some influence over the thing they are investing in because it allows us to increase its value manually, by improving it, by marketing it, etc.  Obviously, this isn’t practical for a lot of people and not possible with a lot of investments, but if you want to get the best returns on a consistent basis it’s practically essential.

Buying something that will increase in value with time generally means it’s just a matter of time before you’ve recovered from any losses that might occur.  Of course you’ve also lost time in there, which might or might not be worth it depending on the alternatives but investing in something that will increase in value decreases the likelihood that you’ll need to worry about that lost time.

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How to Decrease Risk & Increase Return Part 4

Investing

I see a lot of people who get focused on possible risk while missing out on guaranteed risk, that is to say cases where you are guaranteed to lose money.

It is possible to beat other people in the same market simply by minimizing or eliminating these guaranteed forms of risk.  Most people reading this are probably sitting there saying “What’s he talking about guaranteed risk?”  After all, who would invest in a way that they were guaranteed to lose money?  The reality is the majority of people do it without knowing it.

So let’s ask, what are these guaranteed forms of risk in most investments?  Some might argue fraud but that’s not what we’re talking about.  Some might argue paying more for something than it’s worth and that’s fair, but not really what we’re referring to here.  There are two ways primarily that you are guaranteed to lose money that can be mitigated to some extent, they are taxes, and fees.  What then is the rule if we want to decrease risk and increase returns?

Minimize taxes and fees

Before I continue on let’s be careful because some fees actually add value so being able to sort out where value is added or not is an issue.  It’s also a fact that the people who help us need to earn a living as well so it’s fair to pay some fees on some transactions.  However, there are also a lot of fees that don’t add value, and a lot more fees that can be avoided.

Let’s talk specifically about fees and what kinds of fees can show up in most retail investments, since this is what most people invest in:

  1. Marketing fees – different investments pay these out in different forms but you can’t get around the fact that every investment needs to be marketed and consequently you’re giving up your returns by investing with them, in the exempt market these budgets typically range from 10-15%, meaning they have to get a rate of return with just 85-90% of your money (remember what we said about the impact of losing money?)
  2. Administration & Management fees – this includes everything from picking the investments, to doing research, getting approvals, paying for office space, paying to send correspondence to the investors, paying for recruiting, management, computers, phones, office supplies, legal structuring, accounting, etc. these vary wildly but a typical mutual fund will charge about 2.5%/yr. of the money under management whether you make money or lose money that year, private equity firms tend to charge 2%/yr., other companies bury the fees all over the place but the point is it hurts your rate of return
  3. Transaction fees – a lot of people don’t realize that what’s called MER (Management Expense Ratio) in mutual funds doesn’t cover the actual transaction fees when buying and selling individual stocks, a similar fact is true for realtor fees when buying and selling properties
  4. Profit – don’t forget that in addition to the fees the people offering and managing the investment need to make money so they are going to take extra out for themselves, in venture capital and private equity this is typically 20-30% of the profits, again, it can vary wildly from one investment to another

All of these fees added together it is very reasonable to expect that in a lot of investments they can reduce your returns by 50% or more, which is partially why it is almost impossible for investors to get a consistent rate of return in excess of 15%/yr. because to get an actual 15%/yr. means the company needs to have generated at least 30%/yr. which is wildly unlikely in most cases on a continual basis.  This is also why learning to invest yourself and investing yourself gives you an intrinsic advantage, though of course you have to factor in the cost of your time to learn it, to do it, etc.

Bottom line, you can often increase your returns simply by decreasing or eliminating  lot of these fees, consider that a 10% marketing fee effectively reduces your investable capital by 10% compounded over the term of the investment.

What about taxes?

Some people will say “the only guarantees in life are death and taxes”, this might be so, but there are definitely ways to reduce those taxes.  The most common ones come in essentially 4 different forms:

  1. 401K, TFSA, RRSP, Permanent Life Insurance, etc. – investment vehicles designed by the government to help tax shelter your money (may vary by country) can increase your returns simply by decreasing your taxes
  2. Write offs – by paying attention to your legal structure when investing you can get write-offs to decrease your taxes (for example you can write off certain expenses against rental income on a rental property)
  3. Capital Gains & Dividend Income – there are various types of investments that are taxed differently, by paying attention to the tax type and factoring it into your rate of return calculations you can increase your income (this can also be done through flow through shares though they need to be evaluated carefully)
  4. Sourcing Income In a Lower Tax Jurisdiction – on the extreme level this can mean moving to another country with lower taxes (Sir John Templeton the famous billionaire founder of the Templeton fund is famous for this), or setting up a legal structure in another country with lower taxes though this requires careful planning, but could also mean moving income to another province or state within your country where tax rules are superior (Tony Robbins is famous for having left California to avoid the high taxes there).

There’s a lot to be said about taxes and they really need to be evaluated on a case by case basis but suffice to say this can be a significant source of lost return.  For example, an 8% return if taxed as interest income at the highest rate (approx. 40%) becomes only 4.8% after taxes and you can earn that with guarantees inside a life insurance policy.

One particular way people incur excess taxes and fees though is worth noting, or rather there’s one way you can really minimize taxes and fees while at the same time making your life easier:

Avoid money churn

Think about those marketing fees discussed above.  Every time you sell out of one investment and buy into another investment you incur those fees.  You also incur taxes every time you sell.  Why is this so bad?  Because it undermines your compounding, it can actually be compounding in reverse.  If you can find great investments and hold them for as long as possible you’re in the best position.  Every time you can avoid churning your money you have effectively decreased your risk and increased your return.  This is partially why Warren Buffet aims to hold most of his investments for decades, he has deferred tax bills in the billions but so long as his money keeps growing in the same investments as before he doesn’t need to worry.

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How to Decrease Risk & Increase Return Part 3

Investing

There is a truth that the value of things, what they are worth changes.  It might not change as fast as the price, at least not in all cases, but it definitely changes.  What does this mean for us?  It means we can buy something for less than it is worth in today’s market but have it become more than it’s worth in tomorrow’s market.

What does this call our attention to?  Market cycles.

We need to be aware of market cycles.

The markets tend to follow relatively predictable patterns over a relatively long period of time, much like the seasons, in fact they are often defined as the financial seasons.  If you take time to think about them the pattern is pretty obvious.

Things start out relatively flat, we sometimes call this a sideways market.  Essentially, during this period industry, etc. is either recovering from challenges, or building up momentum.  In either way we don’t see dramatic changes during this stage of the cycle.  This momentum gradually mounts, people start making more money so they spend more money, which means other people make more money so they have more to spend, which means demand increases and prices rise, as prices rise people make more money, which further increases the cycle.  This is what we call a bull market, a boom, it rises fairly rapidly.

At this point the speculators get in there, they see everything going up, they are excited about it and figure because of the upward momentum they can make money by paying more for something than it’s worth, which drives prices even higher, but it also carries the seeds of the boom’s demise.  At some point we realize things are over-priced, there is no longer a correlation to value, this occurs when people have over-extended themselves, they’ve spent more money than they can afford to spend.  The result is they default on their obligations and they are forced to sell what they bought for less than what they paid for it.  Because they lost money they have less money to spend so they buy less so demand decreases and prices fall somewhat, though they typically don’t fall as much as they rose (for example they might have risen 100% and now they fall 30%).  This is what we call a bust or bear market.  It tends to overcorrect downward as investors panic, recovers slightly, and is followed by another sideways market as the market recovers from the loss and then rebuilds momentum.

Investment Cycles

This cycle repeats itself over and over again on both a grand and local scale.  Oh there are little bumps here and there, real estate for example tends to heat up in spring and cool down around Christmas but in a general sense the big moves occur corresponding to this cycle.  Yes, you still find companies that grow during busts (Apple being a great example in this past recession), but the overall market follows this pattern and the pattern affects the swing of virtually all companies to at least some extent.

The majority of wealth is built by buying when things are flat or have just crashed and selling late in a boom, then repeating the process.  This is part of the reason it takes a fair amount of time to get wealthy, because a person generally needs to ride at least one cycle.  (It’s useful to check out Ray Dalio’s video on How the Economic Machine Works for another side of cycles and predicting them at www.economicprinciples.org )

I hope looking at this cycle you can understand how it could be possible to buy for what seems like a good deal at the peak of a boom and still lose money as it all collapses around you.  This is why Warren Buffet says “try to be greedy when others are fearful and fearful when others are greedy”.  People tend to be greedy when the market is late in a boom and fearful just after a crash.  So how do we decrease risk while increasing returns?

Invest counter cyclically

Investing counter cyclically means you buy when everything goes down and you sell when everything goes up.  When your next door neighbor is deciding to get into real estate development you know it’s time to sell.  The best part about this is not only does your money go further when the market crashes but people are much more susceptible to negotiation as they are in more desperate positions, the inverse is true during a boom you can often ask more than market value for what you’re selling and get it as the speculators show up, thereby setting the new standard.

When you buy for below what something is worth at the bottom of the market it’s hard to lose money.

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How to Decrease Risk & Increase Return Part 2

Ray Dalio

It’s almost impossible to consistently apply this next principle without following the first principle so if you haven’t read part 1 of this series I’d recommend going back and reading it.

This is a point we touched on at the end of the discussion on risk.  If you want to simultaneously decrease risk and increase return what is one of the simplest ways to do so?

Buy for below what it’s worth.

This can easily be explained with some simple math.  Let’s say you buy something worth $100k for 10% less than it’s worth, in other words you buy it for $90k.  In order for you to lose money, the value has to decrease by $10k, the likelihood of that happening will depend on what it is and over what time period, but suffice it to say the chances of losing money are lower if you bought it for $90k than for $100k.

The reverse of those numbers is also true.  If you buy something worth $100k for $90k if it goes up by 5% to $105k have you made more or less by buying for $90k?  More of course, in this case you’ve made $15k whereas if you’d purchased for $100k you’d only have made $5k.  The impact of these differences decrease as the rate of growth increases of course, but they will always remain.  This is really a classic application of the “buy low sell high” concept, the only difference is here we are putting it into the context of value to make the application easier.

What is necessary in order to buy for below what it’s worth?

It might seem obvious to some but few seem to apply it, the first step in buying something for below what it’s worth is:

You need to first know what it’s worth.

How do you do that?  Well, this is where understanding what you’re investing in comes into play.  It requires immersing yourself in the market.  For example, before buying my first house I went and physically looked at over 100 houses.  Why?  So I’d know a deal when I found one.  The same is true when I buy a car, I look at so many deals for a particular type of car that I can quickly identify the ones that are below the market value when they come up.  Because value is dictated not by the object itself but by the market you can’t get around this basic requirement:

You must immerse yourself in the market.

Immersing yourself in the market alone isn’t enough though, it provides a slight advantage but there are three other very helpful lessons:

  1. Know something the market doesn’t – ever hear about how people make a lot of money on insider trading? What are they really doing?  They are learning something about the market that the majority of the market, which determine the prices for things, doesn’t.  Similarly you need to know more about the value of your chosen investment area than others so you can find good deals that others have overlooked
  2. Negotiate a better deal – there is a basic truth in life that you don’t get what you pay for you get what you negotiate. The same is often true with investments, some area obviously easier to do this than others, but the fact remains that you can often negotiate a lower price than the asking price, and in so doing decrease your risk while increasing your return.  What do you need to do in order to make this possible?  Improve your negotiation skills.
  3. Find less efficient markets – market efficiency is really a measure of how quickly and how accurately the market prices things. For example, foreign exchange markets are very efficient, general public markets like the TSX and Dow Jones are also highly efficient and getting more so all the time.  By contrast smaller markets like the Venture Exchanges, S&P 5000, etc. are less efficient.  MLS is more efficient than Comfree, which is more efficient than private sales.  Do choosing less efficient markets ensure or even increase your chances of not losing money and increasing returns?  No, definitely not.  On the other hand it’s easier to find deals, that is to say there are more pricing errors and more significant pricing errors on average in less efficient markets than in more efficient markets.  This is an advantage a small investor has over a large investor; they can look at small deals where there are little pockets of inefficiency and take advantage of them, where those are too small to justify the time and effort for large institutions.

Buying for below what something is worth takes time and effort.  It is not a quick lazy path, but it’s a path that can pay huge dividends (literally and figuratively), and it is one essential aspect of decreasing risk while increasing return.

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How to Decrease Risk & Increase Return Part 1

Warren Buffet

We talked in a previous post of the definition of risk as “the probability of losing money.  Using this definition the next question becomes “how can we decrease our probability of losing money while increasing our returns.”  Please note, that according to this definition the lower the probability of losing money the greater the probability of making money.  However, we need to factor magnitude in there, in other words how do we simultaneously decrease the chance of losing money and increase the magnitude of money we make?

Anyone can decrease their risk by going into an insurance product or insured investment; say buying a GIC or Canada Savings Bond they can avoid losing money in most cases.  The trick is how do we also get high returns?  Certainly not in a GIC, Canada Savings Bond, or Insurance product, at least certainly not in today’s markets.

The first method takes work; I don’t believe there is any escaping this basic fact as we pursue higher returns and lower risks so here it goes.

Invest in things you understand.

To illustrate the point consider driving in a car.  If you are going to drive from your house to your place of work what is the probability you’ll get into an accident?  Relatively low.  Now consider having your 12 year old son drive your car from your house to your place of work, what’s the probability he’ll get into an accident?  Relatively high.  What changed?  The route was the same, the conditions were the same, the car was the same but in one case it was very risky, in another it was not, the difference was just the driver, specifically, the skill level of the driver.

The same is true in investing.  Your chances of losing money investing with Warren Buffet are less than they are if you are investing with your 10 year old son.  Why?  Simply because Warren Buffet is very skillful at investing, he understands it.  If you want to get good returns you need to learn about what you’re investing in, that will allow you to identify risks and avoid them, it will also allow you to pick winners.  In investing like everything else one thing remains true:

There is no protection from ignorance.

If you don’t know what you’re getting yourself into you can’t protect yourself from it.  This takes discipline, a friend of yours might come along and say “hey, I’ve got this great investment” and it will be something you don’t understand, what should you do?  DON’T INVEST!

If you’re going to invest in stocks you need to understand stocks, you even need to understand the type of stocks you’re investing in.  If you want to invest in real estate you need to understand real estate.  This isn’t easy, it takes a long time to learn a field well, you’ll generally make mistakes along the way.

Bottom line if you want to expand what you’re investing in you should first expand your knowledge into those fields.  If you want to get better returns with lower risk you need to first deepen your knowledge and investing skills in those areas.

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How to Decrease Risk & Increase Return – Introduction

Risk

The goal of every investor, the goal of learning to be a better investor, ultimately comes down to this, learning to simultaneously decrease risk while at the same time increasing return.  Remarkably the two are linked as we’ll see in subsequent posts as we explore the principles behind doing so.  It is possible as proven by some investors who have consistently delivered high returns over long periods of time.

What will follow are a series of principles to help you do so.  There’s something important to understand though, these principles do not function in isolation.

No one strategy will prevent you from losing money while increasing returns.

Each approach has holes in it, does that mean you can’t make money with it?  No, you definitely can as people have proven.  However, you can also make money playing the lottery; it’s just not consistent or predictable.  Our goal here is to achieve consistent and predictable results.

To achieve consistent and predictable results we need to pay attention to each of the principles and strategies, we need to discipline ourselves to their use.  That’s not always pleasant, but it is wise, ultimately, in the long run, we’ll end up way ahead by doing this.  So always remember:

All the principles synergize together to produce consistent results but ONLY together.

What follows then is an exploration that started with Warren Buffet’s first rule of investing, how not to lose money.  It is not enough just to understand the rule, it is critical to understand HOW to follow it.  The principles that follow will allow us do so.

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What is Risk? Not as obvious as it might seem!

Taking Risk

Risk is a scary word thrown around a lot in the investment community.  Go to the bank they’ll talk to you about risk.  Go to a government website on investing and they’ll talk about risk.  There’s a big problem though:

Not everyone means the same thing when referring to risk.

I’m going to illustrate this point by asking you to refer to your common sense.  We’ve all heard the phrase “the greater the risk, the greater the reward”.  Let’s put that into the context of a sports team and try applying the same logic.  A sports team is going to a game and I say “the greater the chance of losing the better the chance of winning”.  Does that make any sense?  No, it makes no sense at all.

Why do I use this example?  Because it proves that the definition I believe most people care about when referring to risk isn’t the definition we generally hear.  Before we look at that definition though let’s look at the two other common definitions of risk.

When a bank says “risk” they are generally talking about volatility.

What is volatility?  It’s the amount the value will shift up and down.  For example, a GIC doesn’t shift up and down; it is always worth its face value, so it is described as “very low risk”.  A bond on the other hand might vary in value over time but ultimately is worth the face value so it is “low risk”.  A fund of stocks will vary wildly, it could swing 10-20% in either direction so it’s considered to be “medium risk”.  An individual stock on the other hand could double in value or lose all its value, so it’s considered “high risk”.  An option is like a stock but moves even faster because of leverage so it’s “very high risk”.  According to this definition the statement that “the greater the risk the greater the reward” is true because the more the value can change the farther it can go up and the farther it can go down.  This doesn’t mean it’s likely to do either of those things, just that the potential is there.

Volatility is not risk, volatility is volatility.​​​​

How do I know the above statement is true?  Because if we pick a bunch of investors and ask them whether they mind that the investment is going to go up and down a lot so long as it goes steadily up by a fair amount will they care much?  In general, no.  In other words, the average person isn’t concerned so much with how much the investment is fluctuating; they care whether they lose money!

In that sense volatility does add some risk, because you don’t know what it will be worth at a particular point in time when you might need to sell an investment.  But it’s a component of risk, not risk itself.

Let’s look at the next definition:

When the government says “risk” they generally mean “exposure”,

Exposure and volatility are linked and exposure and risk are linked, but before we explore that let’s talk about what exposure means. Exposure essentially refers to how significantly changes in the market will affect the amount of money you have. By this definition cash is virtually a risk free “investment” (I’ll show later how it’s the exact opposite but we’ll get back to that).

To understand this concept let’s compare four investment classes: options, mutual funds, principle protected notes, and a GIC:

  1. Options – in the case of an option a small change in the market results in a large change in the amount of money you make, in other words your money is very exposed
  2. Mutual Funds – in the case of a mutual fund a change in the market results in a more or less equivalent change in the value of your investment
  3. Principle Protected Notes – in a principle protected note there are two components, the first is the portion that’s directly exposed to the market, the second is the part protecting your investment, as the market changes over time this ratio can change meaning fluctuations in the market can impact your return less than the total fluctuation itself
  4. GIC – in this case the value doesn’t change at all, it is fixed along with the return

Note that according to the government definition the top most (options) are the most risky and GICs are the least risky.  This is perhaps a better definition than volatility, but still not perfect, because it still doesn’t really address the thing I believe most investors (myself included) consider important, which is our definition:

Risk is the probability of loss.

What I really care about as an investor is “what is the chance that I’ll lose money?”  And the second question is “how much money might I lose?”, in other words “how much am I risking?”.  Is it fair to say this is actually what you care about when you’re thinking of risk?

Using this definition let’s re-examine some of the basic investments and then go look at some of the less conventional ones.  When buying a GIC what is the chance I’ll lose money?  About as close to zero as you can get, the only real risk is inflation, so a GIC is legitimately low risk, likewise for a savings account.  How about a mortgage, if I lend money on a private mortgage what’s the chance I’ll lose money?  Relatively low because I have the property backing it, more importantly, the amount I’ll lose is limited, this is why banks lend money at their lowest rates on mortgages.  What about a mutual fund?  Generally, a mutual fund has two things going for it.  First, if you can afford to hold it long enough you probably won’t lose money, so it’s sort of medium risk (we’ll get into more details here in a moment), so the risk in a mutual fund is really the volatility risk.  Second, a mutual fund is structured in such a way that you can’t lose all of your money, so in that sense it’s lower risk.

Now, I don’t want to get into individual stocks, options, real estate, etc. just yet because here we get into nuances, which is according to this definition we’ve stated we can no longer evaluate risk by investment class, we need to do it on an individual basis.  In other words, not all blue chip stocks have the same risk.  Not all real estate has the same risk.  Not all options have the same risk.

There will be several posts to follow on this subject but just to illustrate the point, if I buy a property for less than it’s worth does my risk go up or down?  It goes down.  If I buy it for more than it’s worth does my risk (probability of losing money) go up or down?  It goes up.  The same is true for stocks, bonds, options, etc.  The point is once you’ve learned this definition of risk you can start to look at different ways to mitigate that risk and not just paint all investments within a given class with the same brush.  This is how you get superior returns.

If you’ve got investing questions you’d like to discuss or like us to cover please click in the lower right corner of the screen to send it to us, looking forward to hearing from you.

​Where Are You In the Wealth Journey and What’s the Highest Impact Objective For You Next?

Wealth Scales Map

Why is Not Losing Money so Important? (Not the reason you think)

​For anyone who has followed Warren Buffet’s investing philosophy his perhaps most oft quoted statement is:

The first rule of investing is don’t lose money.  The second is never forget rule #1

Since Warren Buffet is based on personal wealth the world’s best investor it might be a good idea to listen to what he has to say, we’ll explore it in detail over several other posts but for now let’s start by asking the question, why is this so important?

Why is it so important not to lose money?

On the surface there are lots of reasons, you’ve worked hard for your money you might as well take advantage of it, losing it would be like going to work for free and there are few people who would want to do that.  But you have to remember Warren Buffet wore shoes with holes in them and declined expensive wine because he’d rather have the money to invest.  In other words he’s coming at it from the perspective of maximizing your investment, which in turn will maximize your ability to live whatever life it is you choose.

So from the perspective of investing why is it so important not to lose money?

To understand the answer to that question we need to do some simple math.  If you lose 10% of your investment, in other words say you had $100k to invest and you lose 10%, you’re now down to $90k, what rate of return do you need to get to bring you back to $100k?  Most people will guess 10%, after all, a 10% gain should cancel out a 10% loss right?  WRONG!

10% of $90k is only $9k, so you’re $1000 short even though you go the same rate of return as you lost (not to mention the lost time where your money could have been earning money for you).  You actually need 11.12% to bring you back up to that $100k mark you started at.

A 10% example isn’t that dramatic after all we can tell ourselves getting an 11.12% return is reasonable.  But let’s look at a 20% loss.  So your $100k is now worth $80k.  What rate of return do you need to get back to where you started?  Answer 25%!  In other words by taking a 20% loss you increased the return you need to get by 25% over and above what you lost to begin with.

What about if we took a 50% loss?  Our $100k invested is now worth $50k?  Here you need to DOUBLE your money just to get back to where you started.

You need a 100% return to recover from a 50% loss!

Keeping in mind Warren Buffet, the world’s best investor averages a 20% return per year how likely is it to recover from a significant loss?  Not very.  Over the last number of years only 0.6% of mutual funds have beat the S&P 500, which from 1950 to 2009 including both dividends and price increases has averaged 11%/yr.  If you could beat the market by enough to recover your lost money wouldn’t you be doing it daily anyway?

In other words the math shows us losses hurt us more than equivalent gains help us.

Bottom line is losing money, especially large amounts, set us back so far that it’s almost impossible to make up the difference.  Don’t lose money!

If you've got investing questions you'd like to discuss or like us to cover please click in the lower right corner of the screen to send it to us, looking forward to hearing from you.