Investing entails several inherent risks. In the case of equities, investors generally think of risk as the possibility of losing money relative to the initial investment. Bond investors have many commensurate risks to consider, but most will be thinking about the interest payments relative to the risk of default or an adverse movement (increase) in interest rates. Either of those cause the value of the bond to deteriorate. Investors should also consider liquidity risk, or the ability to convert an investment to cash quickly and without detrimental impact to the price. Correlation risk is another important consideration. If investments across a portfolio are highly correlated, or more importantly, become highly correlated in an adverse market environment, the result is too many eggs in one basket. For the purpose of this brief discussion though, let’s ball all of these risks into one, and say that, generally speaking, the more risk you assume, the more potential return you should expect. This is true of stocks, bonds, private equity, hedge funds, commercial real estate, and maybe even Bitcoin!
One thing we like about using indexed investment products, beyond their generally low fees and excellent liquidity, is they are very precisely aligned on a risk/return basis. If you want the risk/return profile of the S&P 500 as an example, buy VOO (the Vanguard ETF we use), and voila, you are precisely aligned from a risk/return standpoint. Contrast this with your average mutual fund manager who is trying to beat the S&P 500 to justify their significantly higher fees. TINSTAAFL (There Is No Such Thing As A Free Lunch) dictates that to get that higher return, mangers invariably assume higher risk. This higher risk can come in many forms, several of which were outlined above. Regardless of whether it is the manager of a huge mutual fund or your local stockbroker buying individual stocks and bonds for you, they are generally gaming the risk spectrum to tilt returns favorably. Sometimes these strategies work for a period, but as pointed out in our prior article, “Active vs. Passive Investment Management,” roughly 90% of managers miss the mark in the long run, after their fees have been deducted.
We will cover this more in our next article, but global fiscal and monetary accommodation have obscured, or perhaps perpetuated, excessive risk taking in many areas. Given the period of exceptional returns we have enjoyed, perhaps a cycle of mean-reversion is not too far off. As our readers know, we are not market timers. However, we do think it is always a good idea to know precisely what your risks are in both equity and bond portfolios, and perhaps even more so at a time like the present.
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