August 12th, 2010 14:27 EST
Risk: In Investing, It's Everywhere
Most investors incorrectly think of "risk" as the possibility that the market value of a financial asset might fall below the amount that he or she has invested in the asset. OMG, how could this be happening!
Think about it. The harboring of these misconceptions (that lower market price = loss or bad and/or that higher market price = profit or good) is the greatest risk creator of all. It invariably causes inappropriate actions within the large 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" property through time-restrained futures speculations. Anything that is "marketable" is subject to changes in market value. It is as the gods intended, and portfolios can be designed so that it just doesn`t matter quite so much as you`ve been brainwashed into thinking.
What is abnormal is the hype surrounding market value changes and the hysteria such hype causes among investors. No way should a weak real estate market translate into near zero bank balance sheet entries --- it just doesn`t compute, except when it is popular politics.
Similarly, the reality of financial-impact cycles (market, interest rate, economy, industry, etc.) just doesn`t fit at all into the hindsightful, but popular and generally accepted, calendar year assessment mechanisms. Brainwashing again.
The amount, cause, frequency, range, and duration of market value change will always vary in an "I-don`t-care-who-you-listen-to" unpredictably certain way --- the certainty being that the change in market values of investment assets is inevitable, unpredictable, and essential to long term investment success.
Without these natural changes, there would be no hope of gain, no chance of buying low and selling higher. No risk, no profits, and no excitement--- boring!
The first steps in risk minimization are cerebral, and involve developing an understanding of the fundamental economic purpose of the two basic classes of investment securities.
From the investors` perspective: (a) equity securities are expected to produce growth in the form of realized capital gains, and (b) income securities are expected to produce spendable (or reinvestable) income. But it isn`t real growth until it`s realized, or real income until it`s received.
Alternative investments? These are the contracts, gimmicks, commodities, hedges, and other creative ideas that college textbooks used to call speculations. Once upon a time, fiduciaries, trustees, and unsophisticated individuals weren`t allowed to use them. The stigma is gone, but the artificial demand adds risk to all markets.
They are especially risky for the millions of 401(k) and IRA investors who probably cannot explain the difference between stocks and bonds, from any perspective. Most investors have virtually no clue what is actually being done inside the products they select, and have even less of an interest in learning about it. They dance knee-jerk style to the daily media buzz.
Wall Street knows this, and takes advantage of it mercilessly. In spite of the recent financial crisis, pension plan fiduciaries (particularly in the public sector, go figure) are falling all over themselves to throw money at the very alternative and derivative speculations that crashed the market just months ago.
401(k) participants are force fed products du jour from self-serving providor menus that make little effort to identify risk, much less minimize it. Very few plans allow participants to develop an understanding of their investment choices with the only education provided by the product vendors themselves.
What ever happened to stocks and bonds, the building blocks of capitalism? Do investors recognize the financial interest they have in the very corporations their elected officials are encouraged to tax, constrain, 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 which the salesman can`t explain to you in ordinary English, Spanish, French, whatever.
Of course you would prefer to skip this step and jump right into some new product athletic shoes that will hurdle you over the work and directly into the profits. How`s that been working out for you? It was once written (somewhere): no work, no reward.
Risk is compounded by ignorance, multiplied by gimmickry, and exacerbated by emotion. It is halved with education, ameliorated with cost-based asset allocation, and managed with disciplined: selection quality, diversification, and income rules--- The QDI.
Real financial risk in equities boils down to: the possibility that a company`s stock (that 30% share of your brother-in-laws` pizza parlor) will become worthless as management succumbs to economic forces, and/or mandated costs imposed by outside entities whose edicts must be complied with.
In debt-based securities, risk is: the possibility that the issuer of an interest bearing IOU (the money your spouse loaned her brother at 6% to start flinging pizza) stops or falls behind on its payment obligations and/or declares bankruptcy and wipes out both owner (shareholder) and creditor (bond holder) interests.
Here`s an interesting risk in the securities markets, one that governments have cleverly refused to address for fairly obvious reasons. The "Masters of the Universe" routinely get paid obscene amounts of compensation for risking OPM (other people`s money) perhaps a bit too cavalierly.
Company fails, shareholder interests become valueless, debt obligations are worthless, while the fat cats keep raking it in, even suing to preserve their bonuses. Boardroom corruption, and direct lobbying (another euphemism, for bribing) of elected officials are two additional risks that investors need to be aware of.
Go to: Part II - The Basics of Investing: Cruise Control Hedging
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire`s Secret Investment Strategy"