Most investors incorrectly think of “risk” as the chance 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 the lower market price = loss or bad and/or that the higher market price = gain or good) is the biggest risk creator of all. It invariably provokes inappropriate actions within the great mass of individuals who are uninitiated in the ways of the investment gods.
Risk is the reality of financial assets and financial markets: the current value of all securities will change, from “real” ownership to time-limited future speculation. Anything that is “sellable” is subject to changes in market value. It’s as 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 such hype causes among investors. By no means should a weak housing market translate to almost zero entries on the bank’s balance sheet — it just doesn’t count, except when it comes to popular politics.
Similarly, the reality of financial shock cycles (market, interest rate, economy, industry, etc.) simply does not fit the retrospective, but popular and generally accepted, calendar year assessment mechanisms at all. Brainwashed again.
The amount, cause, frequency, range, and duration of change in market value will always vary in an unpredictable “I don’t care who you listen to” manner — the certainty is that the change in market value of investing assets is inevitable, unpredictable, and essential to long-term investing success.
Without these natural changes, there would be no hope of profit, no possibility of buying low and selling high. No risk, no gain, 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’s perspective: (a) equity securities are expected to produce growth in the form of realized capital gains, and (b) income securities are expected to generate spendable (or reinvestable) income. But it’s not real growth until it’s realized, or real income until it’s received.
Alternative investments? These are the contracts, gimmicks, products, hedges, and other creative ideas that college textbooks used to call speculation. Once upon a time, trustees, trustees and unsophisticated people were not allowed to use them. The stigma is gone, but artificial demand adds risk to all markets.
They’re especially risky for the millions of 401(k) and IRA investors who probably can’t explain the difference between stocks and bonds, from either perspective. Most investors have virtually no idea what is actually being done within the products they select, and have even less interest in learning about it. They dance to the rhythm of the daily rumors in the media.
Wall Street knows this and takes advantage of it ruthlessly. Despite the recent financial crisis, pension plan trustees (particularly in the public sector, go figure) are scrambling to throw money at the same alternative and derivative speculations that crashed the market a few months ago.
401(k) participants are force-fed menu items from self-service vendors who make little effort to identify risk, let alone minimize it. Very few plans allow participants to develop an understanding of their investment options solely through 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 into competitive mediocrity?
Another mental step in risk minimization is education. You just can’t afford to put money into things you don’t understand, or the seller can’t explain to you in English, Spanish, French, or whatever.
Of course, you’d rather skip this step and jump straight into some new athletic shoe products that will get you through work and straight to the bottom line. How did it go? It was once written (somewhere): no work, no reward.
The risk is compounded by ignorance, multiplied by trickery, and exacerbated by emotion. Cut in half with education, enhanced with cost-based asset allocation, and managed with discipline: quality of selection, diversification, and revenue rules: the QDI.
Real financial risk in stocks boils down to: the chance that a company’s stock (that 30% stake in your brother-in-law’s pizza parlor) will become worthless as management succumbs to economic forces and/or costs obligations imposed by external entities whose edicts must be followed.
In debt-based securities, the risk is: the possibility that the issuer of an interest-bearing note (the money your spouse lent your brother at 6% to start serving pizza) will default or fall behind on its payment obligations and/or declare bankruptcy and clear the interests of both the owner (shareholder) and the creditor (bondholder).
Here’s an interesting risk in equity markets, one that governments have wisely refused to address for quite obvious reasons. The “Masters of the Universe” routinely receive obscene amounts of compensation for risking OPM (other people’s money) perhaps too arrogantly.
The company goes bankrupt, shareholder interests lose their value, debt obligations are worthless, while the bigwigs continue to hoard, even suing to preserve their bonds. Boardroom corruption and direct lobbying (another euphemism, to bribe) of elected officials are two additional risks investors should be aware of.
Google: Part II – Cruise Control Coverage: The Fundamentals of Investing
Steve Selengut