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Investing: Reassessing Risk

Posted
7/9/2012 4:07:00 PM
By: Martin Tillier
Referenced Stocks:MU

By Martin Tillier

Risk is bad. We all know this, right? Haven‘t advisors told us for years that we need to minimize risk in our portfolios? As we approach retirement, we are supposed to reduce risk and increase the allocation of less risky assets in our holdings. In many ways this is sound advice, but as somebody with twenty years experience in the world’s financial markets, I see two problems.

1. How do you define risk?

    If you have ever dealt with an advisor, I am sure you have been shown a graph that plots return on the vertical axis and ‘risk’ on the horizontal. What is actually on the horizontal axis is volatility. If volatility and risk are the same, why are they different words? They are not the same. Let’s look at an example.

     

    The above is a 1 year chart for Micron Technologies (Ticker: MU). Micron could be considered volatile, with intraday ranges over 5% fairly common, but is it risky? Well, that depends. The stock has traded most of the year in a range of $5-9. Buying it on the recent dip below $6, with a realistic stop-loss at, say $4.90, doesn’t look that risky to me. Buying above $8, hoping for a break out above $9, however, does. The point is not that you should buy Micron. The point is that if you are only looking at volatility, you are not assessing risk. Buying at $5.50 with a stop-loss around 10% away and a target over 50% away is taking a risk, but a controlled one, for which you could potentially be well rewarded.

    2. What constitutes a ‘low risk’ asset?

      This is where current market conditions make conventional thinking obsolete and potentially harmful to your wealth. The traditional low risk asset is U.S. Government debt. Even if you believe that lending the Government money for 10 years is a good idea, and that you will definitely be repaid, you still have a problem.

      At the time of writing, the yield (annual interest paid) on the US Government 10 year Note was around 1.6%. The latest available official inflation number (CPI ex-food and energy) was 1.7% in May 2012. By investing in 10 year Treasuries you are locking in a loss to inflation. Of course you are protecting against another recession, but is the risk of that really much greater than the risk that the Fed will launch QE3, and introduce more inflationary pressure into the economy, thus increasing your built in loss? There is also the risk to the value of your investment. If bond yields go up, prices go down and vice versa. At these historic low yields it would seem to me that a move up in yield, and therefore down in the value of bond holdings, is more likely than the opposite.

      Many of us have taken severe hits to our retirement savings over the last decade or so. You may well be questioning whether you will be able to retire when and how you had planned. Protecting what you have against devastating further losses is important. I just don’t believe that the traditional way of lowering risk is relevant to today’s market. If you need to grow your savings to get back on track, then you must learn to embrace volatility while controlling risk. Realistic stop loss and target levels each time you make an investment can help you do that.

      One thing is for sure. When a realistic case can be made that the traditional ‘risk free’ investment carries more risk than a volatile stock it is time to reassess what you mean by risk.