As with many areas of financial planning, there is not a blanket statement I can…
It is one thing to understand the universe of investing, but it is another thing to know how to work with it. The universe of investing tells us that any investment that yields more than the safe rate of return comes with risk. Risk can be defined in many ways, but for this article, we will identify these risks as the loss of principle, the loss of purchasing power, the loss of liquidity, and the loss of opportunity.
Loss of principle is simply buying an asset at a certain price and selling it for a lower price (e.g., buying a stock at $10 and selling it at $8). Loss of purchasing power is earning a lower return on investment compared with the rate of inflation (e.g., investing $10,000 at a 2% return but at 4% inflation; earnings are $10,200, but purchasing power is $9,800). Loss of liquidity involves investing in an asset in which you cannot access your funds until a certain time or event (e.g., buying into a promising private company with no ability to resell). Loss of opportunity is receiving a lower rate of return from locking into an investment for an established time period and missing opportunities that produced a higher yield (e.g., locking into a five-year CD at a 2% return; the interest rate grows to 4% the next year, yet you are stuck at the 2% return rate, unless you are willing to pay a penalty). Note that any combination of these four risks can affect whichever investment you make.
So, how does one apply the knowledge of the “universe of investing” to best navigate around these four investment risks? These risks must be considered whenever one is deciding to invest. This may seem simple, but it is far more complex than one can imagine. One reason it seems complex is because most of us want to rationalize an appealing investment and thus do not want to kill the proverbial “golden goose.” Therefore, it is best to confer with someone who is financially savvy to obtain an unbiased assessment of the investment risks and how they can be managed.
Navigating Investment Risks
Let’s consider a few examples. Corporation A is offering a 10-year bond with a 6% return. Sounds pretty appealing given that interest rates are typically within the 2–3% range, and the broker is telling you that it is a safe bet. The universe of investing, however, indicates that the safe rate of return on a one-month Treasury bill is 2%, yet this bond promises 4% more. The U.S. Treasury 10-year yield is 2.75%, but this 10-year bond promises 3.25% more; therefore, there is more than just liquidity risk associated with this potential investment. Loss of purchasing power and loss of opportunity are also possible, but they are not the reason for the substantial added yield. Loss of principle through the possible default of the corporation is most likely the considered risk in this case.
To manage this risk, one must clearly understand the company’s business, balance sheet, and long-term prospects to truly be able to assess the potential risk of principle loss. If you or your financial advisor do not have access to this information, then it would be wise instead to diversify your investment into a pool of similar yielding securities, like a mutual fund. Diversification has the potential to mitigate loss of principle, because one company can lose everything in the face of a corporate problem, whereas a pool of 100 companies can collectively shoulder the default risk so that it is no more than 1% per company. Diversification sounds appealing, but it usually produces a lower yield—by maybe 1%—compared with owning the individual bond. This is an important lesson: When risk is mitigated, there is a cost. Either you buy the bond from a specific company and perform the research necessary to understand the health of your single-company investment, or you diversify your investment and lose some yield to mitigate default risk.
Another example is an offer to buy into a real estate project that is touted to yield a 7% tax-free return. These are truly legitimate deals that may yield a 7% tax-free return. Your financial risk by investing in these deals are liquidity first, loss of principle second, and loss of opportunity third. Most real estate deals are quite liquid. In addition, the selling price at said intervals is not easy to ascertain; thus, there is no assurance that you are getting a real valuation because the true value of real estate is only known when it is sold.
How do you manage these real estate investment risks? First, completely understand the liquidity options (if any), and always assume that you are going to hold until the deal is sold. Never assume that the rosiest 7- to 10-year sales projection is true and set a 25-year liquidation target. Second, you or someone you trust should visit the properties to assess the growth of the community and the current or expected tenants. Third, assess the character and viability of the managing partner. Embezzlement is common in almost any business when there are no solid internal controls. Is the project being audited by a highly credible accounting firm? Last, opportunity risk is knowing that tying up your capital for possibly 25 years will be as good as or better than investing in another similar equity investment with greater liquidity.
Assessing Investment Risk
If you combine the knowledge of the universe of investing with the associated types of financial risks, then you can become a better investor. It is important that you or someone else can make unbiased assessments to determine whether a risk can be managed. There is nothing wrong with taking a risk so long as you can properly assess the associated risks. You may be able to achieve a strong return by investing in a start-up company that has shown a compelling ability to succeed, but in such cases, you should only invest assets that you can afford to lose completely. There is nothing wrong with risk, but there is much wrong with poorly managed risk.