Investment Fallacies: Risk

Dear reader, A continuation of my series on Investment Fallacies. In my newsletter last week I wrote about how many people really mean volatility when they talk about risk: the degree to which something moves up or down in price; or conversely the confidence level you have about the price of something being within a given range.

But there are many different forms of investment risk, beyond just volatility. For example, in analysing a bond, you must also take into account duration, interest rate, credit, market, and liquidity risk. While I won’t go into the specifics of each, for anything you analyse there are always a multitude of risks. It is important to decompose risk into each dimension, and ask yourself if you have truly considered each. Whether you realise it or not, you are often placing multiple implicit “bets” on each risk. For example, buying a USD-denominated bond it not only a bet on the bond, but also a bet on the USD. If you do not want to take on that risk, you should hedge it out. Or at least, realise that you are taking that risk in the first place

But even beyond investment risk, let’s think one level deeper. Why do we make such investments in the first place? While there are sometimes reasons such as intrinsic enjoyment of the activity itself (think about people who bet on horses…or currencies), mostly we invest to make a return on our capital. More specifically, we invest in order to increase our long-term purchasing power. In that sense, failure results from a loss of purchasing power. If you buy a great stock, but end up losing money on the currency, you’re worse off than when you started.

More importantly, it means that you need to take into account the effect investing something has on your total wealth, and not just consider whether or not that specific investment is good on its own. I was once talking to a prominent real estate developer: a billionaire who owned large swathes of land in China. Like many Asian families, over 80% of his wealth was tied up in his operating business. The rest was invested into various homes, and the bonds of other listed Chinese real estate stocks. When I asked him why he had so much exposure to just one sector, he said: “all the other Chinese real estate developers are my friends. I know them, and I know this industry better than anyone. Why wouldn’t I invest into it?”

While that was doubtlessly true, the point is that he was focused on making a good investment, rather than considering his total wealth. Over 100% of his wealth (due to leverage) was exposed to a number of macroeconomic factors that were entirely out of his control. If Chinese interest rates rose, it would have a disastrous effect. Likewise if demand for Chinese property fell, every part of his portfolio would lose money together, at exactly the worst time.

Instead, I counselled that he should allocate his liquid wealth into investments that would do well precisely when the rest of his portfolio did not. That way if Chinese interest rate did indeed rise, his liquid wealth would have a balancing effect. After all, I told him, he was already rich: making a little extra off his liquid investments would have no noticeable impact on his standard of living, or his short-term purchasing power. On the other hand, being invested in the way he was, meant risking total permanent loss of capital.

Likewise, I know many families who refuse to engage in succession planning. Dealing with our own mortality is difficult for everyone. Even Genghis Khan, perhaps the greatest conquerer and empire builder the world has ever known, forgot to pass on any of his knowledge to his children until it was too late. Within two generations his empire had split asunder.

An entire genre of art, Vanitas, was created to remind us that no one gets out of his life alive. There is a saying in poker: that the only way you truly lose is if you run out of chips.

In investing, as in life, you can only get rewarded for taking on risk. The key is to take on risks that you are properly rewarded for. To ideally find risks that are not real risks for you. To make sure that you don’t expose yourself to the risk of permanent loss. That you are antifragile, and not just resilient (perhaps a topic for the future!)

And most importantly: to make sure that you actually want the rewards that come as a result of the risks you take.

Yours Sincerely,
Henry Chong