If you’ve spent any amount of time researching finance, then you’ve surely noticed that there’s a lot of advice to be had out there, even with just a cursory Google search or a bit of Twitter scrolling. That includes my advice, obviously; but I like to think that mine is the good kind.
In general, I find that bad financial advice often takes the form of “if you want to be rich, then do X.” Full stop. Bad advice makes a lot of assumptions about what people want (e.g., a Bentley and a vacation home in the Hamptons) and a lot of predictions about how things will turn out (e.g. “ARKK is gonna totally blow up this year”). It often comes across as pushy, telling you to purchase this or that investment product because OBviously it’s the best choice.
Good financial advice, on the other hand, tends to be more nuanced. It usually sounds something like “if you want Y, then consider X, but also Z and maybe Q too.” It accounts for the fact that everyone’s priorities are different and the future is always uncertain. Yes, there are general trends and rules that apply… but very few things are set in stone the way that dumber (or more dishonest) finance gurus would have you believe.
So today I want to talk a bit about one MAJOR financial topic that attracts LOTS of bad advice, something I’ve touched on a bazillion times elsewhere but is definitely worth considering in itself. Namely, risk management.
- Three Types of Risk
- Three Ways to Measure Risk
- (Almost) Three Wrong Ways to Approach Risk Management
- How to Avoid Risk
Three Types of Risk
If you’ve ever bought anything before, then you’ve probably noticed that a given product or service can be high-quality, convenient, or affordable… but hardly ever all three. It’s never all three equally, and you should be very suspicious if someone claims otherwise. Some might argue for their preferred fast-food joint as an exception to the rule, but think about it – even In-n-Out has its flaws (sorry, but the fries just aren’t that good).
This trilemma between good and fast and cheap is inescapable, so you have to weigh the relative importance of each whenever trying to decide if a potential purchase is worth the price. Similarly, you have to juggle three key factors when evaluating how risky a potential investment is. These are volatility, illiquidity and loss of principal.
Volatility
Price never, ever stays static. Whether for a bitcoin or a 10-year bond or a gallon of milk, the price is always going to be moving up or down. But the slow creep of a bond is very different from the whipsaw movements of cryptocurrency. To be specific, that difference is volatility, or how much a price moves in a given period of time.
Volatility is often used as a synonym for risk in general, because the more quickly a price tends to move, the more likely it is to move quicker than investors do. Which is how they lose money fast – but it’s also how they make money fast. That’s why more volatile assets are simultaneously more intimidating and more attractive to investors, and why we often speak of risk and return going hand in hand.
Of course, while dramatic price lurches are the most obvious manifestation of risk, they’re not the only thing you have to look out for. Towards the end of this post, we’ll look at some big mistakes that investors make when handling risk – all of which result, at least in part, from getting too hung up on volatility and forgetting about two other critical factors.
Illiquidity
Stuff (or “assets,” if you want to be technical about it) doesn’t just magically turn into money when you need it to, but some things turn into money much more easily than others. That is, they’re easier to sell; more “liquid.” Illiquidity, then, is the opposite of that – and a liability that isn’t as flashy as volatility, but still very much a risk in itself.
For example, you can sell $20,000 of bitcoin much faster than you can sell a $20,000 car – so if you find yourself suddenly pinched for cash, the bitcoin could act as a safety net while the car could not (this is especially true if you already rely on the car for, you know, driving places). In that sense, then, a car is actually a riskier asset than bitcoin. In terms of volatility, of course, it’s a completely different story – but that just goes to prove my point.
Relying on either bitcoin or your car for a financial safety net would be incredibly stupid, because both assets carry a high amount of risk. But the type of risk is very different for each, and recognizing that difference is critical. The harder it is to sell an asset, then the less its price moves around and, by definition, the less volatile it is. But on the other hand, the harder it is to sell an asset, then the harder it is to convert into cash, which can leave you high and dry in its own way.
So here’s the kicker: not only is illiquidity less obvious than volatility, it is in fact inversely related to it – making people who are paranoid about one much more susceptible to the other. Far too often, people just get hung up on volatility and completely overlook the other, less dramatic types of risk. And there’s one more of those we should look at, a kind of “equal opportunity” threat that can coincide with both volatility and illiquidity.
Loss of Principal
Whenever you make an investment, you’re putting a certain amount of money that you already have toward some kind of asset or resource, with the hope that it will make you more money in the future. As you may already know, this initial amount is called your principal. Whether you’re “investing” in a stock portfolio or a graduate program or a piece of beachfront property, the idea is the same.
Now think of damage to a building: if a hailstorm ruins the roof and some of the windows, that’s a bummer, but hardly irreparable. If termites or flooding ruin the foundation, on the other hand, that’s a much more serious problem – it may even bring the whole building to the ground if you don’t act fast. Because investment gains grow cumulatively upon each other, a hit to your principal can have a similar effect.
The ways that principal loss can happen are as diverse as investments themselves, and it’s often connected to other risks like the ones we just discussed. That makes it a little hard to summarize in a subsection of a subsection of a blog post. But it’s perhaps most visible in depreciation: that is, when an asset naturally loses value over time, rather than losing value due to price movements or inflation.
This is something that businesses in particular have to look out for, because – to go back to the car example – physical assets are often vulnerable to depreciation. Often, but not always. For example, most cars will depreciate, as will most other machinery. Wine, on the totally- random other hand, does the opposite. The value of physical things over time varies wildly, making depreciation and principal loss a slippery thing to keep track of.
Three Ways to Measure Risk
Standard Deviation
If you’ve ever studied basic statistics, then you’re likely familiar with the concept of standard deviation. Like those other metrics you learned about back in fifth grade (average, median, mode, etc.) any and every data set will have a standard deviation – though calculating it is a bit more complex. It gives a snapshot of how much the data in question tends to vary, whether that’s annual births nationwide or monthly Twinkie sales at the neighborhood mini-mart.
This can be very useful when it comes to considering possible investments. Say you’re thinking of investing in a mutual fund; the standard deviation of its returns over the last twenty years will give you an idea of how much its value might vary over the next twenty years. In a word, the standard deviation serves as a measure of the fund’s volatility.
That being said, standard deviation is still a very basic metric that leaves a lot of stuff out. If our hypothetical mutual fund has a high standard deviation, for example, that only tells us that it had some wonky returns somewhere in that twenty-year span. But it doesn’t tell us how many of those outliers there were, how close together they occurred, nor whether they were unusually high, unusually low or a bit of both.
You’ll probably have to dig into the raw data for those contextual details, which you may or may not have the luxury of doing. The good news is that there’s another common risk metric which, while not much more sophisticated than standard deviation, can add some much-needed context to it.
Beta
If you’re telling a friend about a movie you’ve seen, but that they know nothing about, you’ll probably start by comparing it to some other movie they have seen. Deciding whether to try something new is always easier when we can compare it to something familiar, and this is just as true of investment decisions as of movies. A metric called beta helps us do just that (at least for investments. For movies, I think we’re just stuck with the Tomatometer).
Beta shows how the volatility of one asset compares to that of another. Technically, you can calculate it for any pair of assets, but its most common and straightforward use is to compare an individual asset to the market overall (usually represented by some big index like the S&P 500). A beta can theoretically have any value, but in general it’ll be some decimal point between 1 and -1. It all depends on how similar your two comparison points are in terms of volatility.
A beta of 1 means that the asset is basically in lockstep with the overall market. If the former stays steady, so does the latter. If one suddenly spikes, so does the other, and so on. A beta of 1 is about as vanilla as it gets; but for better or worse, such perfect averageness is rare. Most assets, like most people, have their individual quirks that will set them apart at least a little. And beta will generally reflect this.
To be more specific, a beta between 0 and 1 means the asset fluctuates less dramatically than the market, indicating less risk and generally lower returns. A value greater than 1 shows above-average volatility: more risk but also (again, generally) better returns. And a negative value means your investment is in fact moving in the opposite direction of the market overall. If that happens, well… you might wanna get it checked out, unless you’re doing something exotic like short-selling where such inverse values are expected.
In sum, beta goes a bit deeper than standard deviation by summarizing an asset’s behavior in the context of the market surrounding it. But like standard deviation, however, it still only gives a broad summary of what that asset has done in the past. It doesn’t reveal specifics of that past behavior, and it sure doesn’t predict the future either, because no single metric can.
Upside/Downside Capture
While standard deviation and beta measure the risk of individual investments, “capture” looks at the aggregate risk of a portfolio… and, by extension, the portfolio manager. It’s sort of like a batting average, but for trading. Sort of.
Like beta, capture is all about comparisons. In this case, it tells us how well a portfolio’s (or manager’s) performance compares to that of the overall market. But how it does that depends on how you define “performance.” Average Joe Investor may be more interested in returns, or he may be more interested in safety, and capture can measure how Average Joe’s investment manager has done on either front.
If you’re interested in beating the market and making fat stacks, you’ll want to look at upside capture: that is, how good the manager in question is at exploiting upward trends. For example, if Average Joe’s manager has an upside capture of 134, that means she got Joe’s portfolio to outperform the market by 34% when stocks were on the rise. So you’re looking for a UC that’s greater than 100; the more, the better.
If you’re in defensive mode, however – more focused on minimizing your losses – then you’ll want to look at downside capture. It works the same way as upside capture, but in reverse, showing how well a manager was able to batten down the hatches when the overall market was in decline. You want a DC that’s less than 100; the less, the better. If Average Joe’s manager has a downside capture of 75, it means that, under her management, Joe’s portfolio only lost 75% as much as the overall market did.
Any loss is a bummer, sure… but 25% less loss than average is pretty good. What’s more, we can divide the upside capture by the downside for the all-around picture of an investment manager’s performance. When we do that for Joe’s manager, we get an overall capture ratio of 1.79 (hmm… maybe this is where I should have put in the batting average analogy). That’s definitely good, because anything greater than 1 means the portfolio is doing better than the market overall.
(Almost) Three Wrong Ways to Approach Risk Management
Tons of people approach risk in an all-or-nothing kind of way. People often say that they are “getting in” or “getting out” of the market – but an all-in or all-out mentality is inconsistent with how the stock market works and what it represents. In fact, it’s inconsistent with investment, period. When someone has the wrong idea about investment or gives bad advice about it, it’s usually due to some variation on this all-or-nothing attitude.
Looking for Risk-Free Assets
On one side you have those who exclusively stick to “safe” assets, like bonds or real estate, under the (very false) assumption that such assets are somehow invincible. These investors are generally OK with the lower returns afforded by this strategy, because they get to feel insulated from the scary ups and downs of the stock market. But there are two major flaws in their logic.
First, some of these “safe” assets aren’t actually protected from market fluctuations at all – they just seem to be. The prices of non-traded products like real estate are often perceived as more stable because they don’t appear to change as often as prices on the stock market. But actually, real estate prices DO change just as frequently – you just don’t see it because you don’t get a new appraisal on your house every 0.1 seconds.
Second, while some assets like annuities or bonds are in fact immune to stock market shifts (in the sense that they don’t lose money even when the market underperforms), this immunity comes with its own hidden price: inflation. Over time these assets will lose purchasing power, even if they’re not “losing money” on paper. And in many ways that’s worse.
Gambling with Volatile Assets
On the complete opposite side of the spectrum are the adrenaline junkies. You might picture coked-up day traders like those depicted in The Wolf of Wall Street or American Psycho – but nowadays anyone from suburban teenagers to blue-collar boomers can find themselves in this camp, provided they have Internet access, thanks in large part to platforms like Robinhood that incentivize quick trades of individual stocks.
These are the folks who keep making wild bets on volatile assets like bitcoin or Yeezy sneakers, under the (again, very false) assumption that they have to get lucky sometime. Sometimes, yes, it’s true that “you’ll miss 100% of the shots you don’t take” and the odds will reward perseverance. But these gamblers usually aren’t interested in examining the odds to find out whether that’s the case with their Yeezy sneakers or cryptocurrency of choice. They’ll just swing randomly and, often, dig themselves even deeper into a hole via the sunk-cost fallacy.
So, yeah. Don’t be these guys.
Hunting the Magic Unicorn
A sort of middle ground between these two extremes – but no less irrational – is wanting to have your cake and eat it too. Here you’ll find those investors who keep looking for some mythical sweet spot of huge returns with no risk, and then slowly go crazy as their assets keep failing to meet that impossible standard.
This is different from trying to find a balance between risk and reward, by the way – which is what smart investors do. They recognize that compromise is inevitable; that you’ll have to accept lower returns if you want to mitigate risk, and vice-versa. The dumb investor, however, refuses to accept such compromises, and inevitably throws a tantrum when their magic unicorn of risk-free riches never shows up.
Sure, you might get lucky and have an otherwise low-yield fund unexpectedly pop off. Or, conversely, you might take a chance and buy stock in a tech startup right before it gets a long winning streak. But that’s just dumb luck. The smart investor knows you can’t count on luck, nor can you hope to avoid all losses ever. Bad investors inevitably do one, or the other, or a combo of the two; and bad financial advice encourages them to do so.
And on that note…
How to Avoid Risk
Well, um… I’m afraid you don’t.
As I hope this post has made clear, investment risk takes many forms and there’s no way to avoid it outright. There are only trade-offs between different types of risk.
But don’t take this as gloom-and-doom pessimism. It’s actually good news: it means that, contrary to the promises and threats of bad financial advice, there’s no one right way to pursue financial success. There are ways that will be better or worse for you specifically, depending on what your priorities are and what you hope to accomplish with your money.
Finance influencers on the Internet may know a ton about this or that type of asset, liability or strategy; they may even know a ton about a lot of them. And that knowledge is definitely useful. But they don’t know you and your financial goals. Which, come to think of it, does bring to mind one risk-management strategy that I think I can recommend across the board.
It’s very simple: work with people. People you trust; people who know that nuts-and-bolts stuff about markets and equities and metrics, but who also know you. It won’t shield you from everything, but it will make a difference.