Posts Tagged ‘risk’
Following the post I wrote about deep risk vs shallow risk, I went to Amazon and flipped through Bill Bernstein’s latest book “Deep Risk” to see if he feels the same way as me.
It turns out there is a lot that we agree on, but not everything.
Here’s where we see eye to eye: 1) our definitions of deep and shallow risks are almost the same: 2) we both see market fluctuation as a shallow risk and 3) we both see inflation as the #1 deep risk.
Our agreement stops there however. Bernstein does not seem to believe behavior risk and agency risk are deep risks, as I do. Instead, he mentions the following three risks as deep risks in addition to inflation risk.
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Deep Risk vs Shallow Risk
Posted on: December 24, 2013
Recently, a prospective client of mine sent me an email asking about my thoughts on Bill Bernstein’s new book “Deep Risk.” I have not read the book yet, but I do have my own ideas about deep risk vs shallow risk.
I define shallow risk as a potential loss that you can recover from and deep risk as a loss that you cannot recover from.
Market volatility, for example, is a shallow risk. It is very visible and it is scary, there is even a TV channel devoted to it. (That TV channel is called CNBC.)
But taking on shallow risk is how you earn your investment keep. Thus, it should not be feared, it should be welcomed.
Now what are the deep risks you should ardently avoid? I can think of three: inflation risk, behavior risk and agency risk.
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It is well established that investors’ sense of risk reward is shaped by immediate past experience.
However, investing based on immediate past experience is like driving while only looking through your rear view mirror. It’s a disaster waiting to happen.
The proper way to think about risk reward is to see investing as a risk taking occupation. When there are more job openings than job seekers, wages will rise. When there are many job seekers chasing too few openings, wages will be lower. It’s just simple economics.
In academic circles, this wage of taking risk is called risk premium.
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Commercial property investment
For investors who can’t stomach the volatility of real estate investment trusts (REITs), but also don’t want to get their hands dirty, there is the middle way in real estate investment, namely through a private partnership.
A real estate investment private partnership (REIPP) is a pool of investors’ money that is invested in commercial or residential properties. As an investor, you can contribute capital as a limited partner and let the general partner do all the dirty work. Sounds like the best of both worlds, doesn’t it?
It is emphatically not.
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Meeting Allan Roth
Posted on: September 10, 2012
financial blogging
I was in Denver attending the Financial Blogger Conference (FinCon12), and I was thrilled to meet Allan Roth there.
If you don’t know Allan Roth, for the sake of your financial wellbeing, you should.
Allan is an hourly fee-only financial advisor practicing in Colorado Spring. He also writes an investment column for CBS MoneyWatch. Recently, Jason Zweig invited him to write a column in the Wall Street Journal as well. Read the rest of this entry »
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Is a round of golf all the value you get from your financial advisor?
Why do you charge me 1% every year regardless how well you do for me? I would rather not pay you anything for the first 5% return and split anything above and beyond that.
This is a question a prospective client of mine asked me. Let me explain why this fee arrangement is not in the client’s best interest.
Historically, the mean return of the market is 10%, and the standard deviation of return is 15%. This means the market is equally likely to go up 25% in one year and go down 5% in another.
Despite what they want you to believe, financial advisors have very little control over the market.
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In 1993, the Journal of Financial Economics published “Common risk factors in the returns of stocks and bonds” by Fama and French. They examined bond returns in particular through the lens of various asset return models.
Let’s look at one of those models: the Fama/French three-factor model. The regression statistics of various bond classes are summarized in the table below:
| Bond class | 1-5G | 6-10G | Aaa | Aa | A | Baa | <Baa |
| Alpha | 0.72% | 0.84% | -0.84% | -0.85% | -0.96% | -0.6% | -1.32% |
| Beta | 0.1 | 0.18 | 0.25 | 0.25 | 0.26 | 0.27 | 0.34 |
| S | -0.06 | -0.14 | -0.12 | -0.11 | -0.09 | -0.04 | 0.04 |
| V | 0.07 | 0.08 | 0.14 | 0.15 | 0.16 | 0.2 | 0.23 |
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Volatility does not measure risk. The problem is that the people who have written and taught about risk do not know how to measure risk. Beta is nice because it is mathematical, it is easy to calculate and it is wrong – past volatility does not determine the risk of investing. In early 1980s, farmland that had gone for 2,000 an acre, went for $600 an acre. Beta shot up. I was apparently buying a riskier asset at $600 than at $2,000. Real estate not frequently traded. Stocks give you the ability to measure this volatility nonsense.
Because people who teach finance use the mathematics that they have learned, they translate volatility into all types of measures of risks — it’s nonsense. Risk comes from the nature of certain types of business, and from not knowing what you’re doing. If you understand the economics of the business that you’re engaged in and you trust the people you are partnering with, you’re not running significant risk.
Volatility as risk has been very useful for those who teach, never useful for us.
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On May 13th, the Shanghai Stock Exchange Composite Index (SSEC) for the first time crossed the 4000 level. In just this February, when the index crossed the 3000 level for the first time, it promptly dropped 9%, causing a worldwide correction in stock prices. Who would have thought, in the short 3 months that followed, it would have crossed another milestone.
Indeed the whole country of China is swept into stock investment hysteria. By the end of April, there were 96 million brokerage accounts in the country, three times the number there were last April. New brokerage accounts are opened at the rate of 1 million every 3 days. If you get into a taxi in Beijing or Shanghai, you will likely get a free lecture on stock investment along with the ride; street vendors will offer you free stock tips as you shop and even grandmas and grandpas can’t resist dabbling in and out of stocks with their life savings. (The picture below is a grandpa before a screen of stock prices. The coloring convention is the opposite of the US. Red means profits and green means losses.)
Miracle stories abound as well. There are the usual overnight success stories of somebody (names published in newspaper) who made over a million dollar in one day. There are even stories of chronically sick patients who recovered after winning big in the market.
These anecdotal stories of mania are worrisome enough, they are further corroborated by the unsustainable high average P/E ratio of over 50 in the Chinese stock market.
That’s why I see dark clouds gathering even while many people still see green. Stock market crashes of significant magnitude (> 40%) are never caused by economic problems alone, they are usually preceded by a period of unbridled optimism. The optimism in China now is at a hysterical level and it is unlikely to abate leading up to the 2008 Olympics. What I am afraid will happen is that after the 2008 Olympics or shortly before that, smart money will exit the market. A massive exit could trigger a run in the Chinese market that would spread globally.
What can we in the US do about it? First, don’t panic. The ship that is the US financial system is very solid and resilient, storms (even one coming out of China) will shake it but will not sink it. Second, it would be prudent to raise the cash level of your investment leading up to the Olympics. In case you don’t know, the opening ceremony will be on 8/8/2008, still 445 days away. Third, it is wise to invest in defensive stocks.
As a matter of fact, it is always wise to invest passively.
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