Most investors incorrectly think of “risk” as the possibility that the market value of a financial asset will fall below the amount he or she has invested in the asset. My God, how could this be happening?
Think about it. Harboring these misconceptions (that a lower market price = loss or bad and / or a higher market price = profit or good) is the greatest risk creator of all. Invariably it provokes inappropriate actions within the great mass of individuals who are not initiated in the ways of the investor gods.
Risk is the reality of financial assets and financial markets: the current value of all securities will change, from “real” ownership to time-restricted future speculations. Anything that is “marketable” is subject to changes in market value. It’s how the gods intended, and portfolios can be designed so that it doesn’t matter as much as you’ve been brainwashed into thinking.
What is abnormal is the hype surrounding changes in market value and the hysteria that hype causes among investors. By no means should a weak housing market translate into almost zero bank balance inflows, it just doesn’t compute, except when it’s popular policy.
Similarly, the reality of financial impact cycles (market, interest rate, economy, industry, etc.) simply does not fit at all into the retrospective but popular and generally accepted calendar year evaluation mechanisms. Brainwashed again.
The amount, cause, frequency, range and duration of the market value change will always vary in an unpredictable way from “I don’t care who you listen to”, with the certainty that the change in the market values of the Investment assets are unavoidable, unpredictable, and essential for long-term investment success.
Without these natural changes, there would be no hope of profit, no chance to buy low and sell higher. No risk, no profit and no excitement – boring!
The first steps in minimizing risk are cerebral and involve developing an understanding of the fundamental economic purpose of the two basic classes of investment securities.
From an investor perspective: (a) Equity securities are expected to produce growth in the form of realized capital gains, and (b) Income securities are expected to produce income to spend (or reinvest). But it is not real growth until it is realized, nor real income until it is received.
Alternative investments? These are the contracts, tricks, commodities, hedges, and other creative ideas that college textbooks used to call speculation. Once upon a time, trustees, trustees, and unsophisticated people weren’t allowed to use them. The stigma is gone, but artificial demand adds risk to all markets.
They are especially risky for the millions of 401 (k) and IRA investors who probably can’t explain the difference between stocks and bonds, from any perspective. Most investors have practically no idea what is being done within the products they select, and they have even less interest in learning about it. They dance in the instinctive style of the daily media buzz.
Wall Street knows this and is mercilessly taking advantage of it. Despite the recent financial crisis, pension plan fiduciaries (particularly in the public sector, imagine) are going crazy to throw money at the alternative and derivative speculations that crashed the market just a few months ago.
401 (k) participants are force-fed items of the day from self-service vendor menus that make little effort to identify risk, let alone minimize it. Very few plans allow participants to develop an understanding of their investment options with the sole education provided by the product providers themselves.
What happened to stocks and bonds, the building blocks of capitalism? Do investors recognize the financial interest they have in the very corporations that their elected officials are encouraged to tax, restrict, and regulate competitive mediocrity?
Another mental step in risk minimization is education. You cannot afford to invest money in things that you do not understand or that the seller cannot explain to you in English, Spanish, French or whatever.
Of course, I’d rather skip this step and jump right into some new athletic shoe products that will get you out of work and straight to earnings. How did it go? Once it was written (somewhere): no work, no reward.
Risk is compounded by ignorance, multiplied by tricks, and exacerbated by emotion. It is halved with education, improved with cost-based asset allocation, and administered with discipline: selection quality, diversification, and income rules — The QDI.
The real financial risk in stocks comes down to: the possibility that a company’s stock (that 30% stake in your brothers-in-law’s pizzeria) will lose value as management succumbs to economic forces and / or costs Mandatory imposed by external entities whose edicts must be complied with.
In debt-based securities, the risk is: the possibility that the issuer of an interest-bearing note (the money your spouse loaned your brother at 6% to start rolling out pizza) will stop or fall behind in its payment obligations and / or declares bankruptcy and erases interests of both the owner (shareholder) and the creditor (bondholder).
Here’s an interesting risk in the equity markets, one that governments have cleverly refused to address for pretty obvious reasons. The “Masters of the Universe” are routinely paid obscene amounts of compensation for risking OPM (other people’s money), perhaps too arrogantly.
The company fails, shareholder interests lose value, debt obligations are worthless, while the fat cats keep piling up, even suing to preserve their bonuses. Boardroom corruption and direct lobbying (another euphemism, bribery) of elected officials are two additional risks investors should be aware of.
Google: Part II – Cruise Control Coverage: The Basics of Investing
Steve selengut