I was reading an article the other day about the risks associated with the COVID-19 vaccine. Don’t worry, this is not an article focused on vaccines and whether or not they work! This article simply had me thinking about risk and how everyone talks about risk differently. Some people use risk to balance pro’s and con’s. For example, jumping out of an airplane has pro’s and con’s. The “pro” is that it’s (probably) exhilarating. The “con” is that you could fall to your doom if your parachute doesn’t deploy.
I would say most people look at the above example and fall somewhere on the scale between wrapping yourself in bubble-wrap while staying away from the sun, and diving head first out of a plane WITHOUT a parachute. But what about specific investment situations?
I was chatting with someone recently who mentioned how the they chose bonds and GICs because they are “risk free”.
One of the more common comments we receive as advisors when discussing people’s investments, whether this is in a boardroom or on the golf course, goes something like this, “What kind of return do you guys get? My buddy, so-and-so, got 20% last year.” There’s nothing wrong with comparing returns if done in the context of risk. For example, how much risk did he have to take to get 20%? How has his investment performed in the years prior to last year? People love to talk about the good years. Oddly enough, some of that vigor leaves when they have to disclose the “down” years. So today, I want to chat about risk through the lens of financial planning. Maybe it will shed light on some areas of risk that are not always considered.
Risk comes in all shapes, sizes and perceptions. Risk perception is a key component, because it really aids in developing investor psychology. For example, some people view the S&P 500 (one of the main indexes for the US market) as a ‘risky’ investment. Others would argue the opposite. For the sake of illustration, I’ll argue both sides for you.
The S&P is a risky investment. It is made up entirely of stocks (ownership in different companies) and if those companies drop in value, so does the value of your portfolio. You leave the fate of your wealth in the hands of the men and women who run those companies AND other investors who will buy and sell those companies in bulk, which can sway the demand/supply relationship. In March of 2020, we saw a massive sell-off of stocks that equated to a roughly 30-35% decrease in the equity market. The sell-off was mainly based in fear of the economic forecast for companies, given that COVID-19 had finally made it’s way to North America. Therefore, un-predictable elements can quickly shift the value of the S&P 500 and it is risky.
On the other hand, the S&P is not a risky investment. Some people look at the index and think, “historically, the S&P 500 has always produced a positive return given enough time.” When the market crashed in 2008, there was a massive sell-off of US stocks. Some investors were risk-adverse and moved their investment position to something less volatile (i.e bonds and GICs), but some benefited from a different perspective. They understood that the loss (or risk) only existed if they sold the investment, because given enough time, they would eventually recoup their losses and go on to even bigger gains. And that’s exactly what happened. It was a rough couple of years, but within a relatively short time the market had fully recovered and grew well beyond the values in 2008. The market, over the long-term, is predictable, and therefore is low risk.
There you have it. Both sides of the coin, or in most cases a 100-side dice. Everyone sees risk, and there isn’t one view that is 100% correct or wrong. Other factors have to be considered, such as time-horizon, investment purpose, and comfort.
So, why did my discussion on bonds make me think of writing a blog post about risk?
Out of all common investment vehicles, risk associated with bonds is highly misunderstood.
Disclosure: Many risks associated with bonds have to do with FOMO (Fear of Missing Out).
Take a government bond. Let’s say it’s a 4%/year bond that has a maturity (locked-in period) of 5 years. This bond would pay you 4% of simple interest every year for 5 years. On the 5th year, they would return your initial amount (called principle). This seems pretty low-risk right? It’s essentially an IOU to the government with an interest payment to compensate you for letting them borrow the money. Most people would go to the common sources of risk, i.e. what happens if the issuer (in this case, the government) goes under? Obviously, in a government bond, that is highly unlikely. But corporate bonds have some risk of bankruptcy. What about interest rate risk? This one’s interesting because it’s rarely talked about.
Say you have a 4% bond. Typically, these bonds are ‘non-cashable’ which means it’s harder to get your money out early if you need it. Let’s say your car breaks down in year 2. You may incur a penalty for getting your money back early, if you can get it back at all. The other option is to sell the bond to another investor. This is where we see interest rate risk.
What happens if you try to sell your 4% bond and the current rate for the same bond is 6%? Why would I (as a potential buyer) pay you full price for a 4% bond when I can go get an identical bond at 6%? This is where we start having to take a ‘loss’. If I can get a 6% bond when you’re selling a 4% bond, I would only buy yours if you’d sell it for a discount. Let’s say the principle of yours is $100,000. I may only pay you $98,113.20 for that bond, because at the end of the bond’s term, I will receive $100,000. That extra $1886.80 compensates me for the reduced interest payments along the way. This hurts you as the seller.
The reverse is also true. If the prevailing interest rate drops to 2%, you can sell your bond and make extra money because someone else wants to make 4%/year instead of 2%. That’s interest rate risk.
What about FOMO? There’s a term out there called the “Modern Portfolio Theory“. Before joining this industry, I had heard about it through movies but never really understood what it was. It was created by a man named Harry Markowitz in the 1950’s and theorized a way of lowering risk while maintaining return. A lot of his original ideas are used as rules of thumb in today’s environment because they have proven to be successful. He build the idea of the “Efficient Frontier“. I hope Star Trek fans don’t get too excited, because if they’re expecting another reboot, it’s not coming from Mr. Markowitz.
The Efficient Frontier essentially describes how to allocate your portfolio to reduce or maintain a certain level of risk while increasing return. From the image above, you can see that as return goes up, between ~6% and ~9%, the risk actually goes down. Hypothetically, a portfolio that returns 8%/year could have less risk than a portfolio that returns 6%. The “Efficient Frontier”, or most efficient portfolio, would then be something that returns ~10%.
These numbers have to be kept in context. The 1950’s supplied a very different market expectation than today, but I want to focus on the relationships between bonds and the Efficient Frontier. Most people look at bonds and consider them to be the lowest-risk option. Alternatively, by only being in bonds, you expose yourself to risk that is inherently linked to bond pricing (i.e. interest rates). Markowitz goes on in his theory to talk about how equity components can lower your overall risk by reducing bond-specific risk and trading it for equity-specific risk. The risk is not necessarily gone, but it has been diversified. In the same way we would diversify someone’s portfolio by geography or sector, we should also be diversifying by risk category. By only being in bonds, you potentially miss out (FOMO) on low risk returns in the equity (stock) market.
There are hundreds of different types of risk, but on contemplating the “Efficient Frontier”, I thought about how risk can be perceived. This article is not designed as an instruction to go and buy stock and add it to your portfolio, because from a holistic planning point of view, it may not be necessary. It is, however, designed to bring to light some previously unknown forms of risk that should be considered if you’re a fellow advisor or a DIYer. For all of the investors who have lived by the traditional theory of more bonds = less risk, I challenge you to “Boldly go where no man has gone before!” (Thanks Captain Kirk!).