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BAM Intelligence

Not All Risks Are Created Equal — Bill Morgan

Bill Morgan, Herbein Wealth Management, Wyomissing, PA

Risk is fundamental to almost every decision we make.

When we try a new restaurant, we weigh the opportunity for a memorable dining experience against the risk of getting mediocre food or spending too much. When we take a day off during a big project, we balance the pleasure of a day’s rest against the risk of being seen as uncommitted or unreliable. We constantly weigh risk and reward, whether consciously or not.

Risk opens the door to opportunities that may be better, faster, more lucrative or more satisfying than risk-free alternatives. Risk is also the price we pay to acquire or achieve something we couldn’t otherwise reach.

This is especially true in investing. Risk is the straw that stirs the investment drink. Without risk, an investor would find no opportunity for return beyond the nominal return of passbook savings. Without risk, an investor can’t turn a dollar into much more than a dollar, but an investor willing to accept the possibility of a significant loss may earn a big gain.

Select risks carefully

But not all investment risks are created equal. Some risks create the opportunity for higher expected returns; others do not. Recognizing the difference is crucial.

If we think of investing as a car race, some risks are worth taking for the chance to win. For instance, a driver intent on earning the trophy may need to run the car near its mechanical limits, pass in tight traffic and skip a scheduled pit stop. These risks can clearly improve the driver’s placement and payday, but may also lead to a crash or poor finish.

But some driving maneuvers only increase risk without increasing expected reward. For instance, driving with one’s eyes closed or randomly swerving from side to side greatly increase the range of bad outcomes, but offer little or no prospect of finishing higher in the results.

Investors who knowingly take on greater risk without the potential for proportionally greater financial reward are essentially cheating themselves — paying more for a product than its apparent value. They may justify their choices through other nonperformance rewards, such as the thrill of beating the market now and then. This, of course, is more about gambling than investing.

Compensated risk

So which risks are “worth it”? Risks that raise expected return are referred to as compensated risk; investors accept greater chance of a loss in exchange for a higher expected return.

For instance, stocks face market risk — they rise and fall with economic, political and technological developments. As such, stocks are generally riskier than bonds, and are far riskier than holding cash in CDs or money markets. In return for the greater risk, stocks over the long term typically have greater returns. The added expected return compensates investors for the chance that they may experience a loss of capital.

Likewise, bonds expose investors to credit risk — the chance that the issuer will not make payments of interest and principal as scheduled. Bonds also carry interest rate risk — the chance that rates will rise and reduce the bond’s inherent value. Because of these risks, bonds typically deliver higher returns than cash held in less risky money markets. Investors need these risks to beat the very low but safe returns on cash.

Uncompensated risk

Some risks, however, are not compensated; that is, the investor is not rewarded for accepting a wider range of outcomes. One of the most important examples of this is company risk, single stock risk or stock-picking risk. While trying to pick stocks that will outperform their peers has been a staple of investing for many generations, its risk/reward trade-off is suspect.

Consider two portfolios of equal value. The first holds 100 randomly selected large-company domestic growth stocks. The second contains just one large-company domestic growth stock, XYZ Company, handpicked by an investor or broker.

Research tells us two important things about these portfolios. First, their long-term expected performance will be similar. Landmark studies by Brinson, Hood and Beebower (1991) and by Ibbotson and Kaplan (2000) indicate that asset allocation explains more than 90 percent of portfolio performance, far more than any other factor. Because both portfolios contain securities from just one asset class — large-company domestic growth stocks — we can expect the value of both to move generally in the same direction at a similar pace over the long term.

Second, we can expect the single stock’s performance chart to be much more erratic or jagged than that of the 100-stock portfolio. XYZ Company will be subject to short-term company- and industry-specific influences — such as new regulations, strikes, product demand, competitors, recalls and technology advances — that may make its returns jump one year and dive the next. But in the 100-stock portfolio, some stocks will rise when XYZ falls, and vice versa, muting the short-term impact of any single political, economic or technological development. The risk of a large short-term loss in XYZ is, on average, greater than for the 100 stocks.

These two ideas taken together — asset class is the primary determinant of long-term performance and an individual stock is, on average, more volatile in the short term than its asset class — mean a stock picker assumes greater risk without the compensation of greater expected return.

In the example above, owners of both portfolios might expect an annualized return of 8 percent over many years. Neither portfolio would be expected to gain exactly 8 percent every year, of course. Both performance charts are likely to show significant jumps and stumbles, but the owner of XYZ should expect to endure far wilder fluctuations year to year than the owner of the 100-stock portfolio. These wide fluctuations can be stressful and, if the investor in XYZ must sell during a losing streak, expensive.

Taken to the extreme, consider the greatest danger of all in stock picking — putting all of one’s money on an Enron, AIG or Lehman Brothers. As investors have learned in recent years, the value of seemingly robust companies can slide or collapse with little or no warning. Holding single stocks offers the opportunity for a dramatic home run, but with it comes the possibility for a devastating strikeout.

The risk of missing out

Like stock picking, market timing is a common investment strategy in which the investor assumes uncompensated risk. This practice — trying to jump into the market before it goes up and back out before it declines — sounds appealing, but there is no evidence that market timing can be systematically utilized over the long term to improve investment returns.

Market timing provides no systematic reward but introduces a big risk: being out of the market when it makes a major advance. Missing just a small number of big up days means falling well behind buy-and-hold market performance. For instance, the S&P 500 Index had an annualized compound return of 9.9 percent from 1970 to 2012. However, missing the 25 best single days in that time period would have reduced the return to 6.3 percent.

Market timing and stock picking can be thought of as “risks of bad behavior,” like unforced errors that hurt performance in a tennis match.

In investing, risk takes many forms. Some present opportunity. Some do not. Some are ignored, discounted or misunderstood. Every investment decision should be made with eyes wide open to all varieties of risk with the goal of accepting only those that compensate the investor with corresponding potential reward.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2013, The BAM ALLIANCE

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As a wealth advisor, Bill helps clients build and implement a holistic financial plan engineered for their specific financial situation. He works with a team of other professionals to monitor, update and execute wealth management strategies in pursuit of his clients’ wealth transfer, retirement and tax objectives.

For Bill, the most rewarding aspect of working with clients is easing clients’ worry of financial decision-making so they can enjoy the best times in life and achieve their financial goals. That starts by leveraging his experience in individual taxation, using the information gathered at each visit to provide tax planning suggestions, which in turn offers a very positive tangible result: lower taxes.

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