Staying on Deck
No one invests to lose money, but sometimes that is what happens. What causes losses in investing? Loss happens when risk happens. Unfortunately for you as an investor, risk is still present even if losses don’t happen. Unlike returns, which you can easily measure after the fact, you can’t say that an investment wasn’t risky just because it turned out well.
Your investment may be a home run, but that home run may have been dumb luck. If you persistently swing for the fences, you will strike out most of the time. When you strike out in investing, you don’t get to come up and bat in the next inning. You run out of money.
How you think about risk is crucial if you want to avoid striking out. So what is risk? Risk means all the various ways that you can lose money and the likelihood that those things will happen.
Risk, Meet Price. Price, Meet Risk.
How much you can lose on an investment (risk) is closely related to how much you pay for an investment (price). The size of potential losses decreases the less you pay for something.
If you pay $28 for a share of AT&T, your maximum loss is $28 a share. If AT&T fell from $28 to $14, a common reaction would be: “well that’s a risky stock, it declined 50%,” but if you pay $14 for a share of AT&T, you got a deal, and you can only lose $14 a share. AT&T is the same company either way. Its value doesn’t change, but it is certainly less risky at $14 than at $28.
This concept is true between companies, too. You might regard AT&T as “safe” because its big, well known, has steady contractual revenues etc., but at $28 per share there is a lot that can go wrong that can cause its value to decline below that (not the least of which is its mediocre mobile phone reception). A safe company is not the same as a safe investment.
Compare AT&T to Liberty Starz (LSTZ), a business whose revenues come from its pay TV stations, including Starz movie channel, as well as from providing shows to others like Netflix. This is a more risky business than AT&T. People need their phones more than they need movies. However, at a price of $73 per share, LSTZ’s price represent future revenue and earnings which are lower than their current level, an unlikely scenario given their unfavorable license agreement with Netflix up for renegotiation this year. So, while LSTZ may be a more risky business than AT&T, its shares are a less risky investment at their current price.
Risk and Return: A Messy Divorce
Business schools, financial theorists, ratings agencies and other fanatics will preach that risk and return go hand in hand. They’ll say: “you only get higher returns if you take more risk.” This is true when financial markets work perfectly and efficiently. However, financial markets are inefficient often and sometimes for long periods. During these times of inefficiency investors may find high risk and low return investments or, if they are opportunistic, low risk and high return investments.
Investors in 2004 who thought they had purchased “riskless” AAA rated bonds backed by homes whose prices “never fell” found out that they actually purchased highly risky investments that did lose money and had very low potential for returns. See? High risk and low returns.
When these AAA rated bonds fell by 40% and 50% in 2008, other investors swept in and took them off the hands of the investors who thought they purchased something riskless. These other investors were able to see good value and find bonds with high income backed by fixed assets with the potential for significant capital appreciation. So by 2009, our no-longer AAA rated bonds proved to be lower risk investments with potential for very high returns.
Run(a)way Models
Some folks with expensive computers try to figure out ways to describe risk in terms of one or two numbers. They do this using risk models. Risk models are a lot like runway models: they are seductively attractive, for a while, then, suddenly, they show signs of age and become as popular as men’s skinny jeans.
These models (the risk models, not the runway models) base most of their ideas on average outcomes. The trouble is that real outcomes don’t spend a lot of time at the average, either things are going great and investment outcomes are also great, or the world is ending and everyone is losing their shirt. In either of these cases, your risk model isn’t very useful. In fact, in many cases when risk actually “happens”, risk models would say those outcomes are impossible. Either the models are wrong or real life is wrong. I’ll let you decide. The most important thing to understand about risk is that it is not something that is “understood” or predicted, it is something for which you prepare. Once you start thinking about risk as the long list of bad things that could hurt your investment rather than price volatility or some other number, you can make a judgment about whether your investment is worth the risk. After you decide that your investment can weather the downside scenarios, you can swing at your pitch.