Understanding Investment Risk

by George Hatjoullis

There is a proliferation of bonds offering 7-12% yields. They are often in what seems like a worthy cause (green energy). History is replete with investors stuffing too much cash into high yield investments and then claiming they did not understand the risk. Much of this is simply greed and denial. They cannot help themselves, like addicts. It is also possible that people do not have an adequate grasp of investment risk.

The problem is that much risk discussion is cast in terms of statistics. You will hear of probability distributions,  means, standard deviations, symmetry, normality, fat tails, and even black swans. Not helpful to those that can barely deal with percentages. It is hard to get an intuitive feel for risk in part because it is non-linear. A more intuitive approach might be possible using the idealised frameworks popular in economics and finance.

In economics there is something called the law of one price. An identical goods should trade at the same price. If they do not, an arbitrage is possible. You buy the cheap source and resell into the expensive market and make a killing. The arbitrage process equalizes the prices. Simples! One should apply the same principle to investments. Risk-adjusted they should have the same present value. In an efficient market full of very smart and greedy people, who do understand risk, arbitrage should ensure that this is indeed the case. Let us assume that this applies. What does this mean for Jo Punter?

Compare 1% on a  1 year deposit with a building society up to 85k (essentially free of risk) with 12% on a 1 year unsecured bond issued by some corporate entity. If the market is efficient (in which by definition the law of one price applies) then if you make the two investments a large number times, the average return over all investments will be very similar; basically 1%. In an efficient market risk-adjusted returns are equalised by clever arbitrageurs. In a sense there is no point in investing in anything other than risk-free assets. Except of course that individuals do not, in the short-term, make investments a large number of times.

In the case of the bond you might make 12% next year or you might lose all of your money. If you keep making this kind of investment sooner or later you will lose all or some of your money. You may actually be unlucky and lose all of your money early on and have nothing left in the game. You cannot then make the investment a large number of times. Even in an efficient market where risk-adjusted returns are equalised this is of no value to Jo Punter. A 12% promised return may be appropriate for the risk but it is a promise and you could lose all of your investment in any one attempt.

The solution is diversification. This is how you effectively repeat the investment a large number of times in the short-term. You invest in a fund that buys all of these types of high yield bonds available. It is unlikely that all will fail at one time. Of course some will and this will reduce the return and you will have to pay fees for the privilege. You can still lose money but you are unlikely to lose it all. You stay in the game. It still begs the question ‘why bother?’ since the more diversified and the longer the time horizon the closer the fund return will get to the risk free rate if markets are efficient. If the fund is no riskier than a deposit then the flow of cash will depress the return to the deposit rate.

Now there is a moral to my story (as always). Why are individual low net worth investors encouraged to invest in individual high yield bonds? By advertising to them (it is on the Guardian website every time I log in lately) it constitutes encouragement. Four years ago I wrote The Co-op, Nationwide, PSB, PIBS and diversification of risk. It was a reaction to individual investors whingeing because they had overly committed to PIBS and PSBs and were about to lose the lot. They invested in individual bonds because of the extraordinary high yields. Unless safeguards are in place greed and denial will see this sorry episode repeated again (and again). Caveat emptor cannot apply because people are typically psychologically incapable of assessing investment risk. They see the return but can never see the risk it seems.

Postscript

This blog may be slightly confusing to those that have heard that equities yield more than cash in the long-run. Remember that cash can be risk-free in nominal terms but not necessarily in real terms. The same idealised economic theory thinks in terms of a unique steady state equilibrium real rate of return to which the economy is always converging. In the limit this is what capital will earn in aggregate. For practical purposes it does seem that real total equity return exceeds that of cash over relatively long periods though equity portfolio value may vary a lot at any point in time. The message is the same. Diversify your portfolio!

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