08 Oct The Fatigues
“There are risks and costs to action.
But they are far less than the long-range risks of comfortable inaction.”
– John F. Kennedy
Let’s get something straight; there is no such thing as a risk free investment. It does not exist. It never has and probably never will. Anyone who tells you otherwise is either lying or a fool.
Understand that this is true of everything in life. Every action has a risk; we’ve all just learned to either accept or manage those risks.
For example, driving a vehicle is a very high risk activity. We manage those risks by wearing a seat-belt, driving defensively, using headlights & windshield wipers, having airbags & crumple zones, and much more. The point is, we don’t refuse to drive or ride in a vehicle because it’s risky. What we do is identify the risks and manage them to the best of our ability.
Just as we accept and manage the risks of our day-to-day activities, so too must we learn to identify, accept, and manage financial risks.
I’m reminded of the Seinfeld episode where George Costanza lands a job as a risk management specialist, when in fact he knows absolutely nothing about risk management. He doesn’t even know what it is. Throughout the episode he reads a thick, academic book on risk management and makes some dreadful recommendations to his employer. There’s no reason for us to follow George’s example.* There are only a handful of major financial risks everyone needs to be familiar with and each is easily managed.
First, let’s go over the 2 major types of market risks. Every other risk falls into 1 of these 2 categories, so it’s important to know what these risks are and be able to identify them.
Systemic Risk – a non-diversifiable risk which affects an entire economy or market. The Great Recession is a very good example of systemic risk. Every asset (bond, stock, mutual fund, etc …) in every industry in every country lost value.
Nonsystemic Risk – a diversifiable risk affecting a small part of an economy or market. For example, gold prices began falling in 2012, dropping -36% to current prices. This risk was easily minimized by diversifying assets into different industries (healthcare, finance, industrials, etc …).
All other risks are a subset of systemic or nonsystemic. Most of these risks are relatively easy to manage.
Concentration Risk – the risk of loss from concentrating investments in 1 organization, 1 industry, 1 country, etc … For example, Lehmann Brothers went bankrupt in 2008. Those who had 100% invested in Lehmann Brothers lost everything. This risk is minimized by diversifying among different companies, industries, regions, countries, etc …
Credit Risk – aka Default Risk. The risk that a bond issuer cannot repay its bond(s) as agreed. For example, in 2015 BPZ Resources was unable to pay its bondholders as agreed, forcing it into bankruptcy. Over the next 3 years bondholders recovered approximately $0.35 for every dollar they had loaned to BPZ Resources; a loss of -65%. The risk is minimized by only loaning money to very highly rated organizations.
Currency Risk – the risk that unfavorable currency exchange rates erode or eliminate profit on a foreign asset. For example, an investor makes a 10% profit investing in a foreign company. The investor cashes in (sells) and converts the foreign sell proceeds (cash) to U.S. dollars. The exchange rate is 1:1/2, so the investor’s profit in U.S. dollars was only 5%. The risk can be minimized by reinvesting in the same foreign country, in another country with more favorable currency exchange rates, or using the company’s American Depository Receipt (ADR) instead of directly investing on a foreign exchange.
Horizon Risk – the risk that a person’s time horizon abruptly & unexpectedly changes. For example, a person invests only for retirement, a long-term goal. The person becomes disabled, suddenly changing their time horizon from long-term to immediate. The risk is minimized with good insurance and emergency cash reserves.
Inflation Risk – the risk that purchasing power is eroded by inflation. For example, a gallon of gas cost $0.36 in 1970. That same gallon of gas cost $3.00 in 2018. This risk is minimized by investing for a rate of growth at or above the rate of inflation.
Interest Rate Risk – the risk that a fixed rate investment will decline in value as interest rates rise. For example, if you own a $100,000 1 year bond paying 8% & interest rates drop to 6%, the fair market value of your bond will drop to $75,000. This risk is minimized by keeping emergency cash reserves so that you do not have to sell a bond if the price drops.
Liquidity Risk – the risk that an asset(s) cannot be quickly converted to cash at fair market value. For example, an investor needs $200,000 cash. The investor owns real estate worth $500,000 free & clear, but it cannot be converted to cash quickly. Neither can an equity loan be closed quickly. This risk is minimized by keeping a prudent level of diversified liquid assets available at all times.
Longevity Risk – the risk that a person will outlive his/her assets aka run out of money. This is self-explanatory. A person can run out money before (s)he runs out of life. This risk is minimized with a prudent financial plan.
Political Risk – the risk that a political action results in a loss of value. For example, President Obama took a hardline regulatory stance against the coal industry. The entire U.S. coal industry effectively died out, causing investors to lose money. This risk is minimized by diversifying among companies, industries, regions, countries, etc …
Reinvestment Risk – the risk that an investor will not be able to reinvest a maturing/called bond at the same or higher interest rate. For example, a bond paying 8% interest matures & the current bond interest rate is 6%. This risk is minimized by constructing a bond ladder.
Sovereign Risk – the risk that a sovereign government will not pay its bonds as agreed. For example, in 2015 Greece defaulted on an International Monetary Fund Loan. This risk is minimized by only loaning to the highest rated government entities & diversifying among issuers (governments).
Volatility Risk – the risk that asset prices can move up or down. This is self-explanatory. Prices can, and do, move up & down. This risk cannot be stopped, but it can be smoothed out by investing in assets with a smaller standard deviation.
This lists only covers the primary culprits. There are many more risks, but there is no good reason to discuss them since they are much less common.
As you can see, there really is no way to eliminate risks, but they are easy to manage. If you have a professional financial advisor, and everyone should, (s)he will monitor & manage these risks for you.
Because these risks are so easy to monitor and manage, they are not the real threat. The real threat to most people stares back at them from the mirror every morning. I’ve written about it before, but it’s been a while.
Most people are their own worst enemy. They are their own biggest risk. There are several reasons why, but for our purposes today, we only want to mention 3 of them.
Financial Ignorance – as I’ve written about ad nauseum, most people are woefully ignorant on the subject of personal finance. Their ignorance causes fear, and fear causes foolish decisions. Financial ignorance comes in many forms and appears at many different levels. For example, in 2009 a customer called me with instructions to convert his entire account to cash. “Sell everything before I lose everything!”. I recommended he sit tight and went through all the reasons why, including the fact that he would likely miss the recovery, thereby making his losses permanent. He refused my advice & “sold everything”. That was March 6, 2009, the low point of the Great Recession. On March 9, the market turned upwards and here we are almost 10 years later still enjoying the Bull Market that began on that day. The last time I spoke to that customer was 2014 and his account was still in cash. My prediction became reality. His ignorance caused fear which caused him to make an irrational decision. This risk is easily managed by hiring an educated, experienced, credentialed financial advisor who comes to the table with a wealth of knowledge.
Lack of Objectivity – I’ve also written about this extensively. Objectivity means neutral, unbiased, impartial, etc … The lack of objectivity is primarily caused by 2 things. The first is ignorance (see above). Financial and economic education is sorely lacking in the U.S. Most people have no idea how our economy actually works, how markets work, how to evaluate an investment, and so forth. As a result, people allow themselves to become scared by the media. The second thing is “it’s personal”. There’s a reason physicians aren’t allowed to work on their own family members; it’s personal, eliminating their ability to be objective. You’ve probably heard that “the attorney who represents himself has a fool for a client”. The source of that saying is because it’s personal. The attorney cannot be objective. Lack of financial objectivity comes in many forms and appears at many different levels. In 2016 a customer called me. This customer is very intelligent and very successful in every area of life. The customer had been hearing in the media that if Donald Trump was elected President, the stock markets would “drop 50%”. The customer wanted to “go to cash”. We discussed some things, including the fact that U.S. stock markets have never dropped 50%. Ultimately, I advised the customer to sit tight. The customer converted to cash a few weeks before the election and was still in cash a year later. Donald Trump was elected President and the markets never dropped. In fact, they went up approximately 20% during this time. Our portfolio went up approximately 25%. The customer lost the opportunity to earn a great profit by failing to be objective. This risk is easily managed by hiring an educated, experienced, credentialed, fee only, independent, financial advisor who comes to the table impartial and objective in all ways.
Lack of Discipline – I have written and written and written about this subject. Most people have little to no financial discipline. It can be seen in almost every area of life; eating out instead of a sack lunch; throwing out leftovers instead of eating them; gadgets, gadgets, gadgets; expensive vehicles; overgrown houses; elaborate & frequent travels; and on and on and on it goes. The ultimate result is that people save little to nothing (which is the primary reason there are so few wealthy people). It is also the primary reason people run out of money in retirement. Lack of financial discipline is the source of all kinds of financial ills. Lack of financial discipline comes in many different forms and appears at many different levels. I can tell you about pre-retirees that have not saved a dime. I can tell you about retirees who can’t stick to budget. I can tell about people who abandon financial plans that have been working well for years. There really is no end to the examples I could list here. This risk is easily managed by having a thorough financial plan prepared by an educated, experienced, credentialed, fee only, independent, financial advisor.
Ultimately, these 3 risks; Financial Ignorance, Lack of Financial Objectivity, & Lack of Financial Discipline; are most aggressive, most ruthless, and most common cause of financial despair. They are the risks that people really need to mindful of.
No one goes through life without taking risks. It is simply a matter of knowing what the risks are and managing them to your benefit.
*Seinfeld, Season 8, Episode 6, “The Fatigues”, first aired October 31, 1996.
Sapiat Asset Management is an independent registered investment advisor, specializing in financial planning based, asset management for Gen X Individuals & Families and their Trusts & Businesses.