The Investment Scientist

Posts Tagged ‘risk

images-46Following 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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images-54Recently, 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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Look forward when investing.

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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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 »

Golf ball

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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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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