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Chapter 3: Taming the Beast

By: Investor Solutions

Risk is the central problem in the investment process. Specific techniques allow investors to mitigate the effects of each type of risk. In each case, at best, these techniques offer limited relief. In other words, you can get a lot of help, but there are no miracle cures.

As we discuss each of the classic risk classes in turn, remember that while none of us can entirely avoid risks, we can pick and choose the risks we wish to bear. Also keep in mind that we should expect to be compensated for risk, and that without risk, no one could expect rewards above the zero risk rate of return. Having said that, please understand that I am not advocating excessive risks. Investors should carefully evaluate which risks they will bear, and chart a strategy with the highest probability of maximizing their rewards.

Don’t take this discussion to an illogical extreme. Recently the airways have sprouted infomercials advocating everything from penny stocks to speculations in home heating oil or soy bean futures. Each carefully explains that there are risks but also opportunities for huge rewards. These are sucker traps, an almost sure disaster. Keep a healthy level of skepticism, and remember that there are still lots of con artists out there. There is a basic difference between investments in which you should expect to make a profit over time; zero-sum games in which you should expect eventually to get wiped out (gambling, options and futures); and fraud, where you never have a chance (penny stocks). Always remember: “If it sounds too good to be true, it probably is.”

Business Risk

Business risk is the risk most investors first consider. Many fearful investors see their investments being wiped out by a business failure. A business need not fail to cause your holdings to be unprofitable. It can come on hard times, which will severely affect the value of its securities.

Even large, established institutions can disappear suddenly and without a trace. Over a two-year period, Miami residents lost three major international airlines, their largest bank, and their largest savings and loan. Equity investors received nothing.

Entire industries can decline and fade as their products become obsolete. There are few remaining buggy whip manufacturers, and we can assume that equity investors in that once-thriving industry are dissatisfied today.

Other industries find themselves unable to compete in a shifting global economy. America no longer manufactures a single color TV set. Our shoe industry has almost vanished. Again investors in individual firms have suffered.

Disasters can strike at any time from strange and unexpected directions. Utility investors suddenly found themselves evaluating their atomic exposure after Three Mile Island. Orange County bondholders endured a different type of business risk when they found that an obscure bureaucrat had put one of the richest counties in the country into bankruptcy. Texaco, one of the world’s largest oil companies, found itself in bankruptcy after it interfered in an acquisition by a relatively tiny competitor.

We live in an age where that which should never happen – does!

Of course, investors have every right to find this distressing. Fortunately, this risk can be reduced to the point of insignificance. Diversification is the basic investor protection strategy. Diversification offers the only free lunch in the investment business. If an investor owns a single stock, and that company goes broke, the investor has lost his entire portfolio. If the company that went broke is only one-tenth of one percent of the investor’s portfolio, the investor will hardly notice. Single companies often go broke. Entire markets do not!

As the number of positions held increases, business risk falls very rapidly. Statisticians often claim that as few as 10 to 15 stocks will offer adequate diversification, and that after that, further risk reduction reaches a point of diminishing returns. As a practical matter, investors of very modest means can own diversified portfolios of thousands of stocks by using no-load mutual funds or other pooled investments. Business risk is effectively removed as a serious concern.

It’s very important for investors to understand that expected rate of return does not fall as a result of diversification. Only the variation around the expected rate of return falls. And, variation is risk!

Investors are never compensated for a risk that they could have diversified away. Securities are priced assuming that investors hold diversified portfolios. Almost any basic finance textbook will explain the math, and no one with an IQ over room temperature will dispute the benefits of diversification. You may assume that this is a fundamental, undisputed truth.

Here’s another fact of life: For every fundamental, undisputed truth, eventually someone will devise a ridiculous distortion. Diversification has been used as a rationale for some pretty dumb investment schemes. In the name of diversification, everything from collectable plates and dolls to oil wells, gold, diamonds, oil paintings, futures, commodities and even more blatant scams have been palmed off on unwitting investors by slick salesmen. While diversification is the best thing an investor can do to reduce portfolio risk, a dumb investment is always a dumb investment.

The rational investor will consider the merits of each investment before she includes it in her portfolio. Investments should have attractive risk-reward characteristics as well as add a diversification benefit to the portfolio. We will come back to diversification effect when we discuss Modern Portfolio Theory.

Market Risk

No matter how many issues we hold in a market, we find that there still remains a risk that won’t go away. What we are left with is market risk. Market risk is often called “non-diversifiable” risk. No matter how well an individual company performs, its price may be affected by broad market trends. Any neophyte on Wall Street will quickly tell you that “a rising tide will carry all boats,” and “few stocks can swim against the tide.”

Earlier we made the argument that market risk was primarily a short-term problem. As a result, equity investments are not suitable for short-term obligations. I use this rule of thumb: Any known obligation coming due within the next five years should never be covered by variable assets (stocks or long-term bonds.) In addition, investors should have all of their insurance needs covered and a healthy cash reserve before beginning a long-term investment plan. I never want to be in a position of having to liquidate stocks at a loss to cover an expense I should have anticipated.

Markets do not all move in the same direction at the same time. A properly diversified portfolio will have assets in several markets or segments of markets. In most years, this will offer significant relief from market risk. However, investors who violate the previous five-year rule do so at their peril. The proper allocation to markets to obtain the maximum benefit from this effect will be the subject of a later chapter on Modern Portfolio Theory (MPT).

Interest Rate Risk

Interest rates affect investments in several ways.

First, as interest rates rise, the value of existing bonds falls. Consider a bond that was issued at par with a 7% coupon rate. One month later interest rates increase to 8%, and the company issues new bonds at the 8% coupon rate. You are an investor with a sum of money considering both bonds. Would you rather have 7% or 8%? Of course, you would like the higher coupon being currently offered. So, in order to induce you to purchase a 7% bond, the holder will have to cut the price of the bond below par. At some price below par, the 7% coupon, plus the appreciation between the discounted price and par, will make the bonds equally attractive to you. But the original owner of the 7% bond has had to sacrifice principal value in order to unload his bond. Of course, if interest rates fall, bondholders will enjoy capital appreciation. The rise and fall of capital values introduces a serious risk in what many consider to be a “safe” investment.

The longer the remaining life of the bond, the more the bond will be affected by changes in interest rates. A bond with one week until maturity will be virtually unaffected by even large changes in prevailing rates. However, the holder of an identical bond with 30 years until maturity will be whipsawed rather violently by even small changes.

Because of this increased capital risk, longer-term bonds usually must provide a higher return than shorter maturities. If we were to graph the yield to maturity of a bond at different maturity lengths, we would normally see an upward slope. This is called a positive yield curve. At times during the economic cycle, long-term rates may not offer any enhanced yield to maturity over short-term rates. This is called a flat or inverted yield curve.

Bond managers spend a lot of time studying yield curves in order to define the optimum point of yield to risk. Conservative investors will prefer to accept a small decrease in yield in order to have a large decrease in risk. More aggressive investors will prefer the opportunity of capital gains in longer-term bonds if they forecast falling interest rates.

Bond traders also spend a lot of time trying to forecast future interest rates. Such forecasts are notoriously inaccurate, and anyone with a success rate of over 40% is entitled to consider himself an expert.

Bonds of high credit quality are less volatile than lower-rated issues. Of course, they must normally provide a higher yield to maturity to compensate investors for the additional default risk they carry.

If a bond manager was convinced that interest rates were going to rise, he would shorten the average length of his portfolio, and seek higher quality bonds. If he is right, this will preserve his principal.

Maturity vs. Duration

Recently a great issue has been made of the difference between maturity and duration. Maturity means just what it implies: the date the bond will mature and receive the principal back. Duration is linked to how much time a bond requires to pay off the principal at its coupon rate. Because the largest part of the value of a bond is the stream of coupon payments, bonds with higher coupons should carry less capital risk. The price at which a bond is purchased will also affect its duration. A bond purchased at discount will have a shorter duration than the same bond purchased at a premium, because principal will be repaid faster due to the lower cost basis. Many mutual funds report both average maturity and duration to help investors evaluate the risk of the portfolio.

Does Capital Fluctuation Matter?

Investors who plan to hold a bond to maturity may be less concerned with capital fluctuations along the way. They reason that they will receive their principal at the agreed date and have already received the agreed income. However, the capital account accurately reflects the investor’s position. For instance, let’s examine the case of an investor who invested $100,000 at 7%, and then found herself in an 8% interest rate environment. Her capital account is down. Had she previously chosen to keep her $100,000 in cash, she could now buy a great deal more income for it. The reverse is also true. Had interest rates fallen in the previous example, our investor would have a capital appreciation, and more income than she could now purchase with his cash.

Effects on Retirees

Interest rate risk also refers to the risk that you may not be able to reinvest your principal at the same rate you had when your bond or CD reaches maturity. After I left the Air Force in 1972, I moved to Miami. For years, my neighborhood was full of retirees who had sold businesses or taken their pensions and invested them at the prevailing high interest rates. Life was sweet with interest rates in excess of 12% and “no risk.” Big boats, lavish parties, and country clubs were the rule. However, over time, the big boats were replaced by smaller boats, and then no boats. My friends stopped showing up at the club. Eventually these retirees left the neighborhood and purchased smaller apartments. None of them had lost interest in boats and parties, or felt their houses were too big. What happened? The income from their CDs fell apart! Each time a CD matured, it was rolled over at a smaller rate. Finally expenses exceeded income, and sometime after they realized that their principal was shrinking, they disappeared.

If we examine the variation in income from CDs, we find that it is very high. From 1981 to 1994, CD rates fell from 17.27% to 3.69%. In other words, income fell by 80%! Of course, on an after-inflation basis, the results were even more disastrous.

The school-book answer for interest rate risk is to arrange a bond portfolio so that maturities are staggered over time. That way not all the portfolio is rolled over at any point, and over the economic cycle, rates may average out.

I would propose that it is inappropriate for long-term investors to place all or even most of their resources in CDs, T-Bills or bonds. Had retirees in 1972 purchased a diversified portfolio including stocks, foreign equities, bonds and CDs, today they would be wealthy. But their perception of risk prevented them from making that decision. To them, equities were risky, and CDs were safe!

Other Interest Rate Effects

Investors must also be aware that the level of interest rates in the economy will have a major influence on all other capital goods. Stocks become less attractive to investors during times of high interest rates. Even if risk premiums don’t change, the zero risk rate goes up with high interest rates. The resulting higher return requirements will cause stock prices to contract. High interest rates are often associated with inflation expectations, generally a sign that the economy is not healthy. Interest costs will impact some businesses much more than others. Financial institutions and highly leveraged companies will suffer. Higher costs to finance real estate will have a major impact on that market.

Some stocks act very much like bonds during the interest rate cycle. For instance, utilities and REITs are often purchased for their dividends by yield-hungry investors. Rising interest rates will tend to depress these stocks in particular.

Currency Risk

International investors quickly discover currency risk. Of course, wherever we live, most of us consider the local currency as the “real money,” and everybody else’s money is “funny money.” So, we have a natural reluctance to trust foreign currencies. But even if we choose not to invest in foreign markets, none of us can avoid currency risk. If the value of our local currency falls, we become poorer because many things we purchase from other countries will cost more.

After World War II, the U.S. dollar emerged as the premier currency on the planet. While still a major world currency, events since then have seen the slow erosion of the once-mighty dollar. As the world recovered from the war, often with generous economic help from the United States, it was natural that other currencies should rise in value.

To be fair, America’s role as world policeman and superpower have contributed to the problem. Whatever else it may have been, the nuclear umbrella wasn’t cheap. However, our failure to maintain responsible fiscal policies, and a chronic balance-of-payments-and-trade problem, have accelerated the slide. In many respects, currency devaluation may be seen as a tax similar to inflation, imposed by the invisible hand on an often-unwitting spendthrift society.

Americans should be concerned about this loss of buying power. As a society, we simply do not possess the political will to reverse the long-term decline of the dollar. But American investors can partially hedge by holding assets outside of the United States. This is a powerful incentive to invest internationally.

International equity and bondholders are affected in a different manner. If you hold stock in a foreign brewery and the country’s currency devalues, the effect on beer sales may not be very great. The value of the business may not be horribly impacted, and for long-term investors the net result may not be very noticeable. However, if you hold a bond, you may experience more dramatic effects. You have had a real loss that may not be made up soon. (The reverse is also true. You will benefit from an upward valuation.) Americans holding foreign bonds have had reasonably disappointing returns for the amount of risk they have endured, while Americans holding foreign stocks have had very satisfactory returns.

Theory of One Price

There is good economic reason for bonds to be more directly affected. The T-Bill is a zero-risk investment for Americans. A short-term investment in German government paper would be a zero-risk investment for a German. There is no particular reason why two zero-risk investments should sell at far different rates in different markets except for currency risk. If there were no currency risk, normal arbitrage would eliminate the difference in returns. So most economists believe that differences in real interest rates are almost exclusively a reflection of currency risk expectations.

To Hedge or Not to Hedge? That is the Question!

In the short term, currency risk can be rather distressing. Local market gains may be offset by losses in currency. Or even worse, local market losses could be compounded by currency losses. So every international investor must decide whether he wishes to hedge against the currency fluctuations. Most developed markets and some emerging markets can be easily hedged for currency risk. But there is a high price in performance. For instance, a perfectly hedged foreign bond portfolio would perform exactly like a T-Bill minus the transaction costs of the hedges. (This again demonstrates that without risk, there is no prospect for higher returns.)

Portfolio managers are sharply divided on the subject of hedging. Some take the position that currency risk will work itself out in the long run, and the price of hedging isn’t worth it. These same managers might argue that attempting to forecast currency swings and to structure the portfolio accordingly can add another element of risk if they are wrong. After all, forecasting is always difficult, especially if it concerns the future. Others believe that they can properly forecast currency swings and add value while reducing risk. The weight of the evidence seems to favor the un-hedged approach. In any event, Americans holding foreign equities have benefited greatly from their currency exposure for at least 40 years, and no end seems in sight for the long-term decline of the dollar.

Other Currency Effects and Problems

As with any other trend, there will be winners and losers. Portfolio managers attempt to develop strategies based on the relative impact on various areas and industries of currency shifts. As almost every schoolchild knows, exports are made more attractive and tourism bolstered by a falling currency. Imports become less affordable, foreign vacations less attractive. But beyond these elementary effects, many interesting trends develop that cause either problems or opportunities for portfolio managers.

As has been demonstrated recently in Mexico, currency changes can have serious effects on the local economy. Mexico provides almost a worst-case example. After their devaluation in late 1994, we expect major economic contractions, very high interest rates, business failures, and inflation. Predictably, the market tanked. (Of course, there is a chicken-and-egg problem here. The economic problems probably caused the currency changes.)

Many foreign governments have tied their currencies to the dollar. As our dollar falls, their exports also become more affordable, and the trend contributes to their economic development.

Most commodities still are quoted and traded in dollars. Companies, industries and countries that are heavy commodity users will benefit from a falling dollar. For instance, if a German company consumes large amounts of oil, and if the dollar is weak against the German mark, their price of oil will decrease even if the nominal price of oil remains flat. That company will experience lower costs, and have higher profits as well. These profits should increase the share value of the firm.

American investors holding foreign stocks will profit, or at least offset some of their losses in domestic holdings. The long-term dollar weakness has been a distinct advantage to America’s international investors. As with most market trends, there are occasional periods of reversal. But the average American’s fear of currency risk would appear unjustified in light of other benefits of foreign investing.

Political Risk

For good or evil, governments at all levels have a tremendous impact on the investment climate. We often equate political risk with international or emerging market investing, but our own markets are just as sensitive. You don’t have to have an insurrection to experience political risk. Political risks include tax, trade, regulation, education and social policies. A government’s attitude on capital and business sets the stage for either success or failure of their economy.

Political risk is not always negative. If we can find a country where political risk is falling, we might expect earnings in the economy to increase as the economy expands. But we also might expect that P/E ratios will expand as a result. Investors will demand less risk premium; put another way, the cost of capital will fall. One of the highest profile international-investment advisors seeks out countries where political risk is very high but improving. (Of course, you still have all the problems of forecasting.) America in the ’80s, the U.K. under Thatcher, and many emerging markets benefited by enlightened governments’ creating more optimum conditions for capital and markets to thrive.

A Bite out of the Old Free Lunch

As you can see, portfolio managers have a full menu of techniques to reduce risk. Many rely on forecasts, and the result will be only as good as the forecast. Some rely on hedging, which will add cost or reduce returns. The one free lunch we have discovered so far is diversification. But diversification has one more dimension that we must explore: Modern Portfolio Theory. This theory adds a new level of risk control which has revolutionized how many large institutions view the investment process. Investors of more modest means can also benefit. In the next chapter, I’ll show you how!