Monday, July 19, 2010

Risk, what exactly is it? Why take it?

Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

One common theme in many of Garth’s posting is that the real risk for people, especially baby boomer is not stock market risk but the risk of outliving one’s money. Therefore one must invest to mitigate that risk and can do so by creating a diversified portfolio that invests in financial assets that will grow and earn at least 6% return, all with minimal risk. People should not be afraid of the risks associated with investing in stocks & bonds, especially those with long time horizon.
 
So what exact is risk as related to stock & bond investing? Is it important?

Risk in financial industry is actually a very complicated subject with volumes upon volumes of research papers and horrendously looking mathematical formulas devoted to measuring and quantify it, optimizing, and making money from it. There are also many kinds of risk including market risk, liquidity risk, counterparty risk, and credit risk to name just a few.

The topic of risk will almost come up one way or another when someone sees an investment advisor. Often, the person will get some combinations of the responses below:
  1. You need to take a certain level of risk to achieve your target return.
  2. You should increase/decrease your portfolio risk to fit your risk profile.
  3. Higher risk means higher return.
  4. You need to have a diversified portfolio to lower risk and volatility. 
Generally though there is no explanation of what risk means and how it relates to your investments. Most people think of risk as how likely am I to lose money and how much can I lose. However this is not the risk that investment products prospectus/financial advisors refers to. Risk when mentioned in this context usually refers to how volatile the investment’s price or daily return is. If the price of a stock does not fluctuate much on a day to day basis then that stock would be considered to be low risk, regardless of its actual return. Conversely a riskier stock is one whose price fluctuates widely on a day to day basis. This applies in general to any investments you can buy. The more widely an investment’s daily price or return fluctuates, the more volatile the investment is considered to be and the riskier the investment is considered to be.

Volatility can be measured in terms of daily price change or daily return, and how widely it fluctuates around the average price or daily return. For example if investment A has a 10 days daily return of: -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1% for a total 10 day return of -1%. Investment B has a 10 day daily return of 1%, 2%, 0%, 1%, 0%, 1.5%, 0%, 1%, 2%, 0% for a total return of 7.5%. However in this case investment A is considered to be a low risk investment because it’s daily return volatility is almost 0. Investment B even though has a higher return is considered to be higher risk because its daily return fluctuates much more than investment A. As well, investment A’s daily price is very close to its 10 day average price while investment B’s daily price fluctuates much more around its 10 day average price (look up standard deviation on wikipedia if you want more information). So risk when discussed in context of investing in stocks, bonds, mutual funds, etc, refers only to how widely the daily price or return the investment you are investing in fluctuates.

Note, in the example above, I’m merely trying to illustrate the point that low risk investments do not mean you will not lose money. However higher risk does NOT equal higher return! This is an extremely important point!

High price or return volatility means you are more likely to have large price movements, either positive or negative, making it harder to predict with reasonable accuracy what likely total return or value of the investment will be in the future. You can estimate a likely range of the investment’s total return or value in the future using statistical techniques but the range will be wide. For a no risk 5 GIC paying 3% interest per year, you can be fairly certain what your return will be each year and how much money you will have after 5 years. With a stock however, it is almost impossible to predict your yearly return or how much your investment will be worth after 5 years. 

So risk and return are linked but the important thing to recognize is one does not guarantee or imply the other. High risk does not mean you will get higher return for taking the risk. Taking high risk merely gives the chance to get higher return but at the price of a higher, potentially, much higher chance of losing a lot of your money! Remember, if you lose 50% of your principle, you will need a 100% return to just breakeven. So if a high risk investments gives 30% chance to make 25%, a 30% chance of 0% return, and a 40% of losing 15% each year, is it really a good investment to make? Is it guaranteed to do better than say a low return investment like GIC paying 3% a year after 10 years? The answer is no, there is no guarantee a high risk, potentially higher return investment will do better over the long term compared to a low risk low return investment. An easy example is the total return of 5 year GIC compared to the S&P 500 Index from 2000 to present. Someone employing a buy and hold strategy or even a dollar cost averaging strategy (purchasing a set amount regularly) buying 5 GIC would probably be ahead of another person invested in the general stock market.

Similarly, while combining a risk free investment with a high risk investment lowers the portfolio risk, it does not eliminate it. Having risk free investments do not mean you can invest rest of your money in high risk, potentially high return assets and achieve a high return or at worst breakeven. 

Risk taking does not in any way guarantee higher return. If high returns are guaranteed just from taking the risk then why is it even risk? Something is high risk because there is a good chance you will lose a lot or all of your money. If there is no risk of loss then it’s not risk!

Lastly, market risk is simply one type of risk in the investment worlds and there are many other risks that are equally or sometimes even more important. Thus, when making investing decisions, just looking at historical return and risk profile is not sufficient to make a decision.

Sunday, July 4, 2010

Thoughts on more investing claims

Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

Originally I was planning to write about personal bond investing, however I decided to postpone that for now. I read this blog called Greater Fool (http://www.greaterfool.ca/) daily. I first started reading when searching around for Vancouver Real Estate bubble. While I agree with the author, Garth Turner, assessments of Canadian’s RE market and some of his thoughts on economy and government policies, I find myself getting quite worked up over some of his financial/investing advices he gives out to his readers. A lot of his claims about stock market and investing are not suitable for the average person and some of them are just frankly dangerous in my view & experience. Yet these claims are given out almost as financial laws/truism. A lot of his readers look up to him as an expert and follows his advice for their real estate and personal finance decisions. I feel a lot of them are likely to be very disappointed!

Due to the number of claims/statements Garth makes this will be the start of a series of posts. This is a good thing as there are a lot of important topics that I can cover and hopefully clear up some misconceptions. For this post I will just list some of the common claims related to financial investing by Garth in his commentary or responses to reader/commenter questions.
  1. Inflation will be a concern.
  2. Interest rate will be going up.
  3. One should have a percentage of assets in gold as a hedge against inflation.
  4. One should stay liquid.
  5. GIC is not an answer going forward and one should not be keeping money in GIC, a guaranteed loss after inflation and taxes.
  6. It’s easy to build a diversified portfolio earn 6% return in the current environment using preferred shares, medium/long term bank/corporate bonds, sector funds and individual stocks.
  7. Buy and hold is not going to work, active trading is required.
  8. Just buying the index will not work, you need to be nimble and buy specific stocks.
  9. Owning bank preferred shares, or bonds can easily get a 6% pre-tax return and they are safe as none of the Canadian banks will fail, and Canadian banks have never suspends dividends on preferred shares.
  10. Owning medium/long market bonds from big corporations are perfectly fine, even for short term, as they are 100% liquid and safe. Even short time frame of less than 5 years.
  11. One should buy preferred shares due to the high dividend yield and tax advantages, even in a rising interest rate environment.
  12. Keep bonds inside RSP, high growth stocks in TSFA, and dividends stocks & preferred share in non-registered accounts.
  13. Do it yourself investing is almost guaranteed to fail, one should find a good financial advisor to handle the investments.
  14. 6% return is a minimum one should get in this market without much risk and any advisor who says it can’t be done should be fired.
  15. The real risk is not losing money but outliving your money.
Well that’s a very long list and covers a lot of important areas. For this post I will simply state my view on each point. Later posts will go into details for those points that I don’t agree with.
  1. Agree – I think inflation might be a big concern going forward, especially if governments and central banks decide to print, print, print.
  2. Agree – Too much debt chasing too little money.
  3. Agree – but not for the same reason. Gold is actually not a good inflation hedge based on performance from 1980s to 2000. However gold is in a bull market and is real money! Understand difference between real money versus fiat currency versus debt-based monetary system and you will know why owning gold is a good idea. Also understand the difference between money, currency, and wealth.
  4. Agree – when there is too much debt and everyone is borrowing, staying liquid is a good idea. However one has to understand what it means to be liquid.
  5. Disagree – While GIC rates are low and heavily taxes, GIC can be a very valuable and useful tool. In fact, over the decade, GICs have beaten the S&P500 and likely TSX300 Indices total return (dividends included). Not bad for something that’s guaranteed a loss after inflation and taxes. I will write more about GIC in a future post as for most people, more often than not, they will do better by having a big chunk of their money in GIC.
  6. Disagree – with long term bonds rates and dividend yields less than 6%, getting a 6% total return after-tax with a balanced portfolio and limited risk is very hard in the current environment. Now if interest rate for long term government bond goes back up to 8% then 6% portfolio return is possible.
  7. Partial Agree – Buy & Hold will likely not work going forward, but timing the market correct is extremely tough, more luck than skill.
  8. Partial Agree – Stock investing takes a lot of time and effort to research the companies to buy and at what prices. Expecting high return simply from buying individual stock or sector funds without realizing the time, efforts, and risk involved is recipe for large losses.
  9. Disagree - Buying bank preferred shared is not without risks. Currently available preferred shares on the market are unlikely to be paying 6% yield. As well, if the preferred are without risk then why aren’t the rich buying them all up? Why did the banks issue them paying such a high rate for something with no risk? How did Citibank and Bank of America’s preferred shares issued in 2007 and 2008 do? A lot of "impossible" things happened during the credit crisis in 2008.
  10. Disagree - Corporate bonds are not liquid and for individual investors, selling them can be impossible sometimes. They are marketable but that’s not the same as being liquid! Bond has a lot of risks that most people do not realize and it’s not easy for the average investors to buy and sell corporate bonds like stocks.
  11. Partial Agree – Purchasing income producing investment in a rising interest rate environment only works if you re-invest dividends, keeps purchasing, and don’t plan on selling. Income producing securities move inversely with interest rates.
  12. Partial Agree – Bonds should be kept in RSP accounts. However keeping high growth stocks in TSFA maybe not the best option for various reasons. Portfolio tax planning is not as simple as where to put different types of investments, even though these are good general guidelines.
  13. Partial Agree – Most people do not know enough, have enough discipline, or have enough time to manage their own portfolio. However the average investors will not be able to access competent, never mind good financial advisors. Those are only available to high net worth clients, those with $5M or more. The average person with less than $500K to invest is not going to be able to hire a good financial advisor; there just aren’t enough of those around. The ones who are good aren’t going to bother with small time clients when they can get clients with $5M, $10M, or more to invest.
  14. Disagree – If your advisor tells you that, keep him/her because he’s telling you the truth! That’s a very rare trait as most advisors will not tell clients any possible bad news or things their clients don’t want to hear.
  15. Partial Agree – Outliving your money is a problem but nothing guarantees that more than risking and losing a lot of it! Risk does not guarantee reward!