I want to return to the first principals of investing. Warren Buffet has his own rules when it comes to investing, "Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1." Technically speaking, everyone who invests does so with the intention of not losing money (I hope), but clearly there are many who have “lost their shirts” after making poor investment choices. The potential for an investor to lose or gain money is largely tied to the amount of risk they tolerate (or unknowingly tolerate).
The body of work concerning risk in investing is a broad topic, but we’ll keep it (relatively) simple here; however if you want to nerd out a bit you can check out this explanation here (be prepared for a rabbit hole crossing professional finance and academia). Largely speaking, most Americans are risk averse in their everyday lives, but something about investing seems to prime the relatively dormant risk addiction among us. The promises of getting rich quick just gets people to bite every so often—think the dotcom boom and cryptocurrencies which both saw huge collapses.1
However, I want to simplify risk here to talk about more conventional investments. Take the 60/40 portfolio, composed of 60% stocks and 40% bonds. Harry Markowitz created Modern Portfolio Theory (MPT) that mathematically stated (not proved in many people’s opinion) that the 60/40 stock-bond split was the optimal structure of a well performing portfolio. Optimal meaning the best balance between maximizing gains and minimizing risk. The structure isn’t the least risky (because that would probably be something simple like investing in I-Bonds or money market funds but you’d see minimal growth), but it tries to achieve the highest gains possible without being overly risky. Variations of the 60/40 exist, especially as guidance to younger investors. The longer you stay in the stock market, the more likely you are to experience gains and longer periods of time usually mean larger gains. Therefore, younger investors may go anywhere from 60%-80% stocks. While this strategy is riskier than 60/40, it is less risky when one considers that a longer window of time will pretty much always mean larger gains. Time is just as if not as important as the investments selected.
Bonds are usually considered to be less risky than stocks. Again, there is a lot of math here because bonds are risky due to duration (and default risk—more on that later). If you need a refresher, harken back to my article on Silicon Valley Bank and their meltdown due to a lack of liquidity caused by reductions in the value of their bonds.2 Duration basically measures how much your bond is worth over time relative to interest rate changes over that time period. The bonds SVB held where worth way more before the Fed increased interest rates. Increasing interest rates increases the price of borrowing money, and all the money previously borrowed at lower interest rates becomes less valuable. Still, (government) bonds provide a guaranteed return. You know how much money you are getting (you just may not know how much that money is worth when you receive it). Slight caveat with non-US Treasuries (bonds not issued by the US Treasury) because there is a higher risk that bonds issued outside the US will default (not be able to pay back the debt), however the risk here depends on who is issuing the bonds. For example, a fiscally stable government like Germany versus a state largely in turmoil like Venezuela. There is a very slim chance Germany will not pay you back, whereas Venezuela honestly probably won’t (Argentina too for that matter). See, risk in investing is like 3-dimensional chess.
Stocks are, relatively speaking, riskier. There are two main types of stock, one being preferred stock which issues dividends to investors, but the stock most of us buy is common stock (which may or may not have dividends). Common stock does not have guaranteed returns. The rate of return is unpredictable and could be negative. Take GE for example, the stock and company was once the most valuable on Wall Street for decades returning large amounts to investors through price growth and dividends, and now it’s a shell of its former self consistently selling parts of its business to stay afloat. To be honest, buying stocks is educated gambling. The reason for the variability of stocks is why indexes like the S&P 500 and Dow Jones exist. They look to minimize risk buy indexing a number of companies together. Therefore the variability (or risk) of one stock is lessened since you are combining its price with a couple dozen or even thousands of other stocks—therefore reducing risk. Still, even indexes are unpredictable, the S&P 500 fell almost 20% last year; while this year the index is up 13% year to date. Even riskier indexes like the technology focused Nasdaq fell approximately 33% last year, yet this year up 26%.
Let’s stop here for now, I threw out a lot of information—and honestly we are just scratching the surface. This post has been a bit of a ramble, but the point here is that risk is a very complicated subject in investing. I hope to further clear up what risk means and how it plays out practically in future posts—though no promise on whether that will be next post or several post from now.
Disclaimer: This is not professional and/or financial advice. This content is for informational purposes only. Before making any financial decisions you should do your own research, evaluate your financial situation, and/or consult a financial professional.
Though now thinking about it if the internet saw huge growth around 8 years after it’s collapse that lasts into today, it may soon be time to reevaluate.
However, most Americans will not face a liquidity crunch like SVB, so don’t take this warning too seriously.