“To him who looks at the world rationally the world looks rationally back.”
—Georg Wilhelm Friedrich Hegel
Risk does not equal reward.
The phrase is illogical. Instead, if you wish to unite the words to their meanings, the phrase should read risk = risk, or reward = reward. Any other association of the words is sophistry or salesmanship. The investment industry, being the chief promoter of this errant formula, should stop using it, because it is misleading and simply wrong.
Philosopher Ludwig Wittgenstein’s elegant principle of logic yields this simple truth: A is the same as A. This is sometimes expressed in the symbols of logic: A ≡ A where “≡” means congruence or two subjects of equal identity. To the contrary, it is absurd to say that risk is congruent with reward, or that risk is identical to reward. Worse, the assertion that risk = reward makes investors believe that dangling at the end of risk is inevitable reward, or that one must necessarily pass through the gauntlet of peril to reach promise on the other side.
Risk = reward associates risk with something positive and links the two as if they were necessary co-ingredients, like water + flour = bread.
I am risk averse. You should be, too. Remember what we are talking about: Your investment is your hard-earned money. If you do not do this right you may never have any more money on which to practice. And, according to a recent AARP survey, “[r]unning out of money (is) worse than death.”1 There is no quicker way to run out of money than to take big risks.
It is important to know what risk is and what risk is not. Faulty characterizations of risk lead to undesired results. This is how many stock averse investors think:
Risk is volatility.
Stocks are volatile.
Therefore, stocks are risky.
Instead, risk must be measured against returns. For example, the notion that Treasury bills are low risk is simply untrue when you factor in the return. In Japan and currently for some bonds in the United States, bond yields are so low that only the principal is returned. So what is risked is any potential of return. One could hardly call this a low-risk investment—that is, if your purpose is to increase your wealth.
Since biblical times, investment return assumes some quantity received in addition to the principal—the lesser of that quantity, the worse the investment. Recall the parable of the nobleman and his three servants from the Book of Luke. The first servant returned 10 mina (mina was the equivalent of roughly three months’ wages) more than was given him; the second servant returned five mina more; the third servant returned only the original mina. The nobleman’s severe response to the risk-averse third servant was, “Why then didn’t you put my money on deposit, so that when I came back, I could have collected it with interest? Take his mina away from him and give it to the one who has 10 mina.” Think of that story while we discuss the relevant definition of risk for savers and investors.
Risk is the possibility of suffering loss or harm. Risk is a relative, not an absolute, measure. Dying, for example, is not a risk. Dying is an absolute: We will all die. If someone asks you what your probability of dying is, your answer would be 100%. However, if someone asked you what your probability of dying within 10 years, or in a car accident, or after viewing your 401(k) account balance, this is an entirely different question, and needs a complex calculation. Risk is measured only in relation to events, consequences, or time. The risk of dying escalates with certain factors such as smoking, not wearing seatbelts, eating fatty foods, and so forth. Therefore, it is not the risk of dying that should cause concern; it is the risk of some unwanted event leading to an early death.
Think of it this way: Would you rather be in a car crash or a plane crash? If you answered car crash, the next question is: Would you rather travel one million miles by car or by plane? If you answered by plane, I might ask why, as you just said that cars are less perilous. You might respond, It depends. If I am traveling 5 miles to a friend’s house I would rather take the car, but if I am going to travel an eight-state region over a 10-year sales career it would be safer to fly. And you would be right.
The Boeing Company claims that it is 22 times safer to fly than it is to drive on a per-mile basis. Fewer people have died in commercial airplane accidents over the past 60 years than are killed in U.S. auto accidents over a typical three-month period. Another study indicates that you have the same chances of dying in a car (one in a million, a MicroMort) having traveled only 240 miles, versus traveling 7,500 miles by commercial aircraft.2 How can this be? Which one is actually safer? How can it be that sometimes driving is safer and at other times an air travel is safer?
Cars are not safer than airplanes. Airplanes are not safer than cars. Instead, safety (or risk) is dependent on the distance traveled. Again to accurately assess risk you always have to measure against the objective. If the objective is a short trip, driving is safer. If the objective is a long trip, flying is safer.
This is much like the benefits of exercise. Exercise is short-term risky when measured against chance of injury, and long-term healthy when adding back the net health benefits. You have a greater chance of injury if you take a 3-mile run or spend an hour in the gym lifting weights versus staying at home and sitting on the couch. To put a number to it, “More than 3.5 million (sports) injuries each year, which cause some loss of time of participation, are experienced by (children and teens).”3 However, long-term exercise is a proven contributor to cardiovascular health, weight control, muscle and bone strength, lower blood pressure and cholesterol, and even relieving depression. Time converts the greater short-term injury risk into a longer-term health benefit. Can you see how risk is actually lower long term by taking part in short-term “risky” exercising?
Risk, then, because it is a relative term, should be measured as a function of the objective. In this case the relative measure is time. As an investor, how much time will it take for you to grow your principal? What will happen over the long term? In 10, 20, 30 years from now, what will your needs be for your money? The objective is not, not (sorry for the double negative) to lose money on any given day. The objective is to reach your long-term goals. Therefore the safest and most reliable way to do that should be preferred.
There are multiple ways to visualize this new definition of risk. Is a gun or a letter opener riskier? It depends. If you replied gun, which would you rather have if someone attacked you? Most would agree that a gun is a more reliable way to neutralize a dangerous threat than a letter opener. Which is riskier: a vitamin or tetracycline? Would you rather your baby swallow a vitamin or tetracycline accidentally? It depends. If she was suffering from an infection you would rather her swallow tetracycline.
Another example: How would you like to have surgery today? Most see surgery as a risky procedure. For starters, you have at least a one in 200,000 chance that you will die if you have surgery.4 According to the Centers for Disease Control and Prevention, approximately 2 million people a year contract infections during a hospital stay, and more than 90,000 die as the result.5
The point is this: You do not decide to have surgery instead of doing nothing; you decide to have surgery instead of suffering the consequences of not having the surgery. Therefore risk is not an event measure (Do I have surgery or not?); risk is an outcomes measure (How will my long-term health be affected?).
This is the same with investing. You don’t invest in the stock market because it is safer. You invest in the stock market because if you do not, you have less likelihood of reaching your financial goals.
Risk is a misunderstood word. How we understand words—more importantly, how we use words—is crucial. If you doubt this, see how the word love is used. It is a word so charged with expectation that the mere mention of it can change a relationship. It is the same with the word risk. Use both carefully.
How you think about and use the word risk will determine what kind of an investor you are. Risk can be a noun, verb, or adjective. My advice is this: Use the word risk as a noun and you will have a better future. And, make you, not the investment, the subject. When you use the word risk regarding investing, ask Am I putting myself at risk? Do not ask about a proposed investment Is this risky? Don’t ask Are emerging market funds risky? Ask Will this emerging market fund put my objectives at risk? There is a crucial difference.
This will help you focus on you and your investment goals and not on the much-less-critical discussion about the investment vehicle. Plus, you are much more capable of evaluating your own risk tolerance than you are the risk of an investment. Far too much time is spent in comparison of this and that data point of a particular investment. We ask questions such as: What’s the beta? What’s the 10-year track record? What asset class is it? Better questions are: What income do I need to have in 20 years? What is my current debt level and how can I reduce it? What investment amounts and returns do I need to reach my goals? My recommendation is that you quit asking questions about investments and start asking questions about you. The wealthiest people I know have no more investment knowledge than you do, but they have detailed personal goals, objectives, and plans. They simply match investments to their plan.
A more ideal use of the word risk will make the discussion less subjective. You are the object, and your goals, not your investments, are the objective. You are the focus, not your tools. We will see in a later chapter that it is investors who make money, not investments, so begin now to wean yourself off the obsession over the investment rather than you.
I have dealt with clients over the years who tell me, “Andy, I just don’t want to take a chance. That’s why I am just going to leave everything in CDs. At least then I am not buying something risky.” Instead, they should ask, “I wonder if there is anything that I am doing to put my retirement goals at risk. Is investing everything in CDs putting me at risk?”
The answer is Yes. The relative low returns of CDs (certificates of deposit) could put your retirement income at risk. CDs are not risky, but depending on CDs for your future income needs is risky.
Similarly, there is no doubt that driving 10 miles per hour is less risky than driving 60 miles per hour. However, you would be putting yourself at risk if you drove 10 miles per hour on the interstate. You would also be putting your sick child at risk if in an emergency you drove him to the hospital at only 10 miles per hour.
Risk as a condition or state has to be dealt with in much more analytical terms than risk as a discrete act. In other words, doing less-risky things can put you more at risk. The risk of the speed you travel, and the investment you choose, is dependent on the objectives of your journey, and the objectives of your savings goals, respectively.
Stocks are riskier if you need the money for a down payment for a new house at the end of the month and less risky if you need to accumulate more assets over a long period of time. The right investment (or speed) will become very clear after you have determined your objectives.
Associated with the errant concept that risk equals reward is the related assumption that volatility equals higher reward. Think about this in the physical world. To say that the average must be higher because of greater volatility is irrational. An analogy is average temperatures. Did you know that San Diego has an average temperature of 70.5 degrees and Atlanta has a lower average temperature of 61.3 degrees? (See Figure 1-1.) Therefore, temperatures in San Diego are more volatile, right? This must be the case if higher volatility equals a higher average, right? Wrong.
The Atlanta Chamber of Commerce is famous (or notorious) for selling the International Olympic Committee (IOC) on this hilarious notion. Atlanta convinced the IOC before the 1996 Summer Olympics that the temperatures were much cooler than they are by averaging in nighttime temperatures. Athletes would soon discover that 65-degree nights don’t make up for 100-degree days.
The greater volatility in Atlanta’s weather should mean higher average temperatures if it is settled science that greater volatility = greater returns. Atlanta average daytime temperatures are much more extreme than San Diego temperatures, but Atlanta is cooler on average.
What I am suggesting by analogy is that there is a San Diego way to invest. You can get to a comfortable room temperature from consistent 68-degree days more reliably than you can get to 68 degrees from an uncomfortable combination of 33-degree and 90-degree days. There is another way to reap higher returns than through unpredictability and numerical frontal assaults on your life savings.
Risk needs to be measured against not just loss, but the timing of loss. For example, life insurance policies don’t protect the insured from dying. Nor do the policies assume that the person will live forever. Life insurance policies protect against an early death.
However, the risk measure for the timing of life insurance policies is opposite of the timing for stock investments. Visualizing this helps to understand the time connection of risk for stock investing. Nothing beats the returns from premiums paid into life insurance policies that pay off early. And nothing beats the returns from stocks that pay off late. The odds are in your favor the longer you invest. Thus, the risk of life insurance increases over time, but decreases over time with stocks.
How is this incremental value for stocks valued over time? Using history as our guide (and it is the best guide we have) there was a 3:1 chance that the stock market rose in any given year, and a 100% chance that you would have made money for any 20-year period or more.
Why is this important? Because of this: The average 65-year-old couple can expect to live another 19 years. In addition, there is a 50:50 chance that one member of the couple will live beyond 92, and a 25% chance that he or she will live beyond 97.6 You need stocks now more than ever because you are going to live longer. No generation until now has ever had to anticipate living in retirement for 30 years, but Social Security now only replaces about 40% of pre-retirement income for today’s average worker.
For a wider perspective, over the last 85 years stocks were up 72% of the time, down 28% of the time, beat 5% returns 68% of the time, and had an arithmetic average yearly return of 11.50%.7 Getting theses odds in your favor will lower your risk.
My belief is risk does not equal reward, and I am attempting to change the way you think about risk. But, let’s get back to the real world for a minute before I get into too much investment detail. Let me ask you if risk = reward with a few questions:
Do you ride motorcycles without a helmet?
Are you happy when your daughter introduces you to her new tattooed, out-of-work, ex-felon boyfriend?
Do you juggle chainsaws as a hobby?
Do you drink alcohol by the bottle rather than by the glass?
Do you refuse to wear eye protection when you use your weed-eater around the yard?
Do you walk close to the edge of cliffs when you hike?
Do you avoid sunscreen on a long day at the beach?
Do you fix shingles on your roof on the day of a snowstorm?
Do you leave your doors unlocked and outside lights off every night?
Do you exaggerate and lie on job applications?
Do you eat junk food at every meal?
Do you refuse to wear seatbelts?
Your answer, I am guessing, was no for all or most of these questions. Each question was the same: Are you a risk taker? Notice that there is virtually no part of your life in which you seek risks. Instead, you avoid risks as a good habit. So, how could it be that in one very narrow but vital part of your life it would pay to ignore everything you believe? How could it be that investing is that one area of your life where taking big risks is advised?
Even though you might agree that risk taking should not be a part of your daily routine, you might still believe that the world of business is different. Hollywood portrays businesspeople as tycoons, wildcatters, roughnecks, devil-may-care opportunists who, from taking huge risks, reap astounding, lavish rewards. Advertising genius Don Draper, from the television hit Mad Men, stuns prospective clients with a provocative pitch off the top of his head. One crazy risqué appeal and—bingo—he closes a huge new advertising deal with General Motors. He shoots from the hip, is dead-eye accurate, and is a winner.
That’s not how it works. As the son of a successful businessman, I saw how it really works my entire life. I watched my father systematically, methodically, intentionally, and purposefully wring as much risk out of his business that he could with strict inventory control instead of foolhardy buying; add staff only when absolutely necessary; be an early adopter of free marketing and sales (the internet); reinvest profits; offer exclusive products that would allow higher margins; and always seek the niche that was underserved rather than the most popular, which was highly competitive and risky. The results were rewards for his entire working and retired life. I learned from my father that low risk = high reward.
You don’t know my father, but maybe you know of Ted Turner—the founder of WTBS and CNN, and one of the largest land owners in the United States. Writer Malcolm Gladwell illustrates the test case in business risk avoidance in a New Yorker article called “The Sure Thing: How Entrepreneurs Really Succeed.” Turner is the model of risk management and avoidance—the real Ted Turner, not the mythic Ted Turner you know—the big sky, big dreaming, “mouth of the south” risk-on rancher. When you discover how Turner saved his father’s billboard business, with no money, from a predator who tried to take advantage of his father’s suicide when Turner was only 24; financed his first television station (WJRJ, Channel 17, in Atlanta) with no cash; and purchased the Atlanta Braves baseball team with a down payment from the Braves, not from Turner, you start to see how his empire was built on the risks and money of others, not him.
How? As Gladwell says, “It’s because Turner is a cold-blooded bargainer who could find a million dollars in someone’s back pocket that the person didn’t know he had. Once you get past the more flamboyant aspects of Turner’s personal and sporting life, in fact, there is little evidence that he had any real appetite for risk at all.”8 Gladwell explains, “Successful entrepreneurs are seen as bold gamblers; in reality, they’re highly risk-averse.… Would we so revere risk-taking if we realized that the people who are supposedly taking bold risks in the cause of entrepreneurship are actually doing no such thing?”9
Sometimes the investment industry seems confused about risk. In some ways the investment industry’s perception of risk is like the tobacco industry. It would make sense because the industries are equally over-regulated by the federal government. Therefore, we are left with a confusing mix of schizophrenic feelings whenever we see an advertisement. For example, there is a cigarette advertisement that shows two coquettishly placed pink and turquoise cigarette packs surrounded by playful dancing roses with the description “light & luscious.” This ad is presumably targeting girls. How do we know? Beneath the ad’s eerie likeness to Joe Camel meets Barbie’s Malibu Beach House is the ominous Surgeon General’s warning that reads “Smoking by Pregnant Women May Result in Fetal Injury, Premature Birth, and Low Birth Weight.”
The it is really good but it will kill you approach is so contradictory that consumers block it out. They have a blank reaction to the warning and rationalize if it were that bad it wouldn’t be legal, and they smoke away. Nor is the industry protected because of this warning. Besides the $200 billion settlement that the industry agreed to in 1998, tobacco companies are still sued daily for millions of dollars despite the fact that they have been telling their customers that their product will kill you for almost 50 years. There are simply no connections among the advertising message, the use of the product, and the forced warning label.
Imagine, likewise, if an airline described flying with the same risk = reward strategy that the investment and tobacco industry uses. Imagine if this was the disclaimer that airlines included with your ticket:
Warning: You are likelier to die or sustain serious injury in an in-flight decompression, explosion, fuselage break, or accident than from a similar automobile crash. There is no assurance that your travel objectives can be met with this airline. Consult with a travel agent before purchasing a ticket.
No one would support this kind of disclaimer. Even consumer safety groups that are overly cautious have not lobbied for this kind of disclosure. Why? I think it is because the airline industry believes in itself more than the investment industry does, and has done a better job of building the safety case for flying. Flying is safer for long trips. Period. The over-preening federal government tends to agree, so no disclaimer necessary. Because the investment industry is so unaware of the true nature of risk, which is not price volatility, but is instead the odds that you will reach your investment goals with any given investment, we acquiesce to confusing and counterproductive disclosures.
Mutual fund prospectuses are where this is most evident. The prospectus for a popular short-term bond fund is 101 pages long, whereas the prospectus for another popular emerging-markets 3x leveraged bear market fund is 88 pages long—13 pages shorter. Just so you know (because you wouldn’t know from the prospectus), the leveraged emerging markets fund is radically more volatile than the bond fund. From December 30, 2008, to December 31, 2012, the leveraged emerging markets fund was down 98.48%. In contrast, for the last 10 years the bond fund has grown like an oak tree: slowly and steadily.
I am not saying that the bond fund is more desirable, will perform better, or belongs in your 401(k) plan, instead of the emerging markets fund. The problem is neither does the prospectus. You can bet that the bond fund prospectus is not 13 pages longer than the emerging markets prospectus because it takes that many more pages to alert the investor to the risks of government bonds. What you can bet is that comparing the prospectuses will not give you any meaningful insight to the differences between the relative risks and rewards of the two funds. That’s where we are as an industry 70-plus years after the Investment Company Act of 1940, which defines and codifies regulated investment companies like mutual funds.
I think you can see that if you want to protect yourself against risk you need information of a different sort. Your security against confusion comes from understanding the true nature of investment risk.
My favorite investor is Warren Buffett, not because he has made the most money, but because he has made the most sense. He may be the greatest investor in history. In his 2007 letter to shareholders for Berkshire Hathaway he wrote, among other memorable gems, that he was looking for a new chief investment officer to replace him. How did he describe such a replacement? He was looking for a person “genetically programmed to recognize and avoid risks,” who shows “independent thinking, emotional stability, and a keen understanding of both human and institutional behavior.”10 This is, in other words, a summary of Warren Buffett’s personal investment temperament and expectations, and how he grew to be the world’s wealthiest investor. How did he do it? He avoided risk.
One apparent choice was Todd Combs. Todd Combs surprised Wall Street because he only managed $280 million before the Berkshire Hathaway offer. But, the choice did not surprise me because Combs has an able background in insurance, worked for the state of Florida’s comptroller, and has experience managing a portfolio of financial companies. In short, he is a risk manager.
Think about that. If you asked the average person how one of the wealthiest people on earth managed to accumulate his fortune, most would say that he did so by taking enormous risks with his money. They would be wrong. Warren Buffett does not purposely take risks with his and his shareholders’ money.
As evidence, when Berkshire Hathaway, Buffett’s company, is categorized (as in the biological hierarchy of family, genus, species, etc.), the sector is financial services, the industry is reinsurance, and the type is “slow growth” according to Morningstar, Inc. “Slow growth” does not sound like high risk to me, nor would it fall into the risk = reward model. Slow growth is how he does it. Slow growth is how we should do it.
Meet Ralph Shive, a Barron’s Top 100 Manager, who recently held a top spot in his Morningstar, Inc. category over three-, five-, and 10-year time periods. Shive said he “learned to embrace that idea that risk is losing money.”11 This does not mean that he is a conservative investor. To the contrary, Shive is described as “reasonably aggressive, meaning that he’s aggressive about making money and also aggressive about preserving it.”12 Note that “high risk” and “aggressive” are not necessarily the same thing. In my experience bigger risks are taken by being too conservative than by being too aggressive. I am not talking about risks from day-to-day price volatility. I am talking about something worse: risks to future income, risks to standard of living, risks to buying power, risks to financial independence, and ultimately risks to your security and legacy. I think Mr. Shive would agree with that.
CNN just reported that the Dow plunged 45 points. What did they not say? They did not say that the Dow dropped .0028 or .28% or $28 of your $10,000 investment. Why? Which data is more useful: a number like 45 without any comparative reference, or a percentage like .28% that gives scale to an increase or decrease? Certainly percentages are more useful than standalone numbers, but the media is inclined to manufacture a story out of every data point. Forty-five points is a story. Forty-five points seems like a lot. If a basketball team won by 45 points it would be extraordinary; .28% however is statistically insignificant—which is exactly my argument. If the media changed overnight to reporting the stock market in percentages instead of raw numbers, eventually they would just stop reporting. Who cares if the market is up or down .28%?
As long as the media talks in terms of the Dow plunging or soaring, then they exaggerate risk and reward. This is not helpful. Why? Plunge talk worries those who are already nervous, and soar talk puffs up those who imagine that they are in a parade every time they see a ticker tape. Who would ever fly in an airplane if it was described in these terms: Fly now if you want to plunge to the ground or soar through the clouds? Besides the transparent desires of the media, if either risks or rewards are either intentionally mischaracterized or simply unknown, then conclusions are naturally erroneous.
Another problem is how we quantify risk and reward. We take risks that are too great for so little reward. Fix that by making a realistic assessment of the reward first, then work backward. We have been so programmed to automatically think that risk = reward that we have also grown to believe that more risk = more reward.
Here is an example. Years ago my oldest brother and I took a trip to San Antonio and the Austin Chalk area of Texas to evaluate investing in an oil well for him. It was a fun and most unprofitable trip. The problem was not just that we did not understand the risk (tip: Don’t invest in a single well), we also exaggerated the reward. Oil will do that. Anyone who saw Giant or Dallas or the Beverly Hillbillies can gin up images of a miraculous life makeover courtesy of a lone deep well spring of Texas tea.
This was not the fault of the oil company executive. He showed us pro formas that illustrated 10–15% annual returns if it struck oil. I remember the numbers not being far off from what most stock mutual funds were projecting at the time. Honestly I think when we looked at the spreadsheets we weren’t seeing rows of numbers; we were seeing Elly May Clampett or Charlene Tilton. When you exaggerate the rewards you will take more risks than you should. Moral: Excitable people should hire someone to make their investment decisions.
Here is another way to think about this. Risk Reward. Or does it? Figure 1-2 is the type of chart used in the investment industry that tries to convince people to invest in stocks. I am trying to convince you to invest in stocks, too—although, you will see, not only stocks in later chapters. However, I do not like charts like these because they only tell you what investments returned, not what investors returned. I have never had an investment for a client, only investors, so I am more concerned with what happens to people than I am with what happens to financial instruments.
Note the relative difference between the highest and lowest return range, and the average annual return range. We have been coaxed into believing (in this case, mostly by my industry) that risk = reward, illustrated here as highest and lowest annual returns equal higher average returns. To me this chart illustrates the opposite. It tells me that the extremes in returns are not worth the marginal returns. The question is not Should I invest all stocks or all short term (presumably meaning money market funds or bonds)? The better question is What mix of investments will most likely help me reach my investment objectives? The person who buys in to this chart and goes 100% all stocks will be out of the market, maybe forever, if his portfolio ever drops by 67.6% (the worst 12-month return). If he sells after dropping 67.6%, he is much less likely to reach his goal. I do not like the approach that says, in essence, if you can survive a 67-foot fall then you can climb to the top of this 162-foot mountain. It creates false choices.
What really happens when investors’ portfolios drop so precipitously is that they give up. Note these revealing charts. These charts measure what happens to investors, not just what happens to investments. Morningstar, Inc. calls this relationship the IR–TR gap for investor return–total return gap. (See Figure 1-3.) IR is how the investor did, and TR is how the investment did. You can see that the Investor Return was higher than the Total Return with low-risk (standard deviation) funds, despite the fact that the higher-risk funds have slightly higher returns. In other words, the lower the risk the higher return—to the investor. Don’t forget: It is the investor that counts (you), not the investment.
In Figure 1-4 shown on page 46, notice the relative returns between U.S. sector funds and balanced funds. Though the higher risk (sector funds) had a higher return, the lower risk (balanced funds) had a higher investor return.
Figure 1-5 also shown on page 46 tells a similar story for an entire decade. Note that in only one case (balanced funds) did investor return actually meet or exceed the returns of the investment itself. In every other fund type investors underperformed; they bought and sold at the wrong times.
The point is that investors (again, we are talking about you now) don’t stick around with investments that are volatile, high risk, or otherwise scary. Because you are an investor, not an investment, focus on what happens to investors, not to investments. We will see how to create a more positive investor experience than the false risk = reward choices that you have been instructed to endure.
