It Is Risky To Misunderstand Risk

How investments work.

Each investment you make is a two-sided arrangement with you as the recipient of value and someone or something else the provider of that value. No provider of value will give you more than they must to acquire the inputs that you put into the arrangement.

Notice inputs, emphasis on plural. Money is just one.

How many inputs are there?

Years ago I made a list of inputs there could be in an investment. There are about 40 and only a few matter to any particular investor.

Some are provided by the investor and some by the investee.  Think of them like buying a car. Here is the base model. If you want optional extras you must pay extra. In the investment case, put in more of something to get a higher yield – nicer car.

From the other side, if you want or need certain investor inputs you must buy them by offering a higher yield.

Negotiating for yield

Suppose I have investable capital, no particular need for the money in the next five years, a high tax rate and I am risk averse.

I have noticed that if I commit money for 5 years, the provider will pay me more than they will for a 30 day commitment. Why will they do that? They want to match their borrowed capital against the lifetime of the investments they make. In a bank, a 5-year GIC offsets a 5-year mortgage. Matching matters.

I have also noticed that a credit union may pay more than the Royal Bank of Canada. I may see them as riskier and thus need to be paid for that.

I might prefer a dividend from the Royal Bank’s preferred stock because it is taxed a little better. For a given chunk of capital, I only care about my useful after tax cash over the time it is invested.

The primary factors

Yield, liquidity, risk, legality and taxation.  Most people look little past here. They miss some factors that might help them. Things like, ease of management, ease of transfer, small minimum purchase, cash income that is reinvestable in the same deal, and value as collateral.

Sometimes they pay for things of no value.

Fashion is the most common. You can’t get attention at the club by buying a bond, but you can if you buy a unit in the next Angelina Jolie movie. Giving up yield for fashion is a separate and non-investment decision.  Many tax shelters fall here.

Of all the factors, risk is the easiest to misunderstand.

Risk means different things to different people. Traditional investment risk is really just variability. What is the range of return you could expect on a one year investment?  Very wide, very risky. Very narrow, less risky. That has nothing to do with money unless you introduce another variable. Will I take the money out on that particular day? If no, then the whole analysis becomes theoretical.

Risk is important because you can lose money permanently.

The problems come in the space between anticipated risk and actual risk of loss. According to Elon Musk, most people over-estimate downside risk. You miss opportunities.

Seth Godin has an interesting thought too.

Feels risky

The gulf between “risky” and “feels risky” is huge. And it’s getting bigger.

It turns out that value creation lives in this gap. The things that most people won’t do (because it feels risky) that are in fact not risky at all.

If your compass for forward motion involves avoiding things that feel risky, it pays to get significantly better informed about what actually is risky

Seth Godin 2 Aug 2017

Emotions harm your approach to investing.

Quantify risk of loss and at the same time assess the risk of gain. If someone offers to play a game where the odds of my winning are one in 50, the cost to play is $10,000 and the payout to win is $1,000,000 I will play that game all day long even though the odds of losing are 98%. It is not about how often you lose. 

I should think about losing AND expectation of gain. My expected win is 1/50 of $1,000,000 each event.  $20,000 to win on average, with a cost of $10,000.  Where do I sign up?

The stock market is like that too, just not as clearly so.  Holding seems to be the win variable. Some people couldn’t handle 49 losses out of each 50 plays. Feels risky hurts them.

Risk is an idea. Learn what it means to you.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. 

In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com  866-285-7772

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