Risk, Return and Method over Madness

“Though this be madness, yet there is method in it.”

– Hamlet Act 2, Scene 2 by William Shakespeare

Risk and Loans

Risk is the chance of a loss.  This should be considered in every investment.

When I loan my money out to someone the money is at risk until such time as I get it back safely in my hands. The more creditworthy the borrower, the greater comfort I have of getting paid back.

The longer the time it is away from me, the more chance that something can happen to the borrower and I realize a loss (this is time risk).  Generally I want to be paid more the longer the time my money is at risk.

The more contractual control, the greater chance that the borrower will keep their word and pay me back as promised.  But the less the borrower is generally willing to pay.

In loaning money, I must consider that stuff can happen to any borrower.  So, I am better off making 100 loans of the same amount to qualified borrowers and diversify this borrower risk.  In effect I become a bank.  The main issue to diversify are the cost and time of finding and keeping 100 qualified borrowers, setting terms with each, and managing the repayment of the loans.

Risk and Tangible Assets

Risk not only exists with loans, but also with ownership of assets – be it hard/tangible assets like land or gold, or other assets like ownership interests in businesses.

In hard/tangible assets, I control the timing of when I sell.  But the issue instead turns into the risk of getting all of my money back.  In a hard asset, the greatest chance of getting my money back is by having purchased it at a discount.  The greater the discount, the greater the chance that in a normal time of selling that I will get all of my money back.  The question is whether I am able to rightly determine the best price of the hard asset for the time to when I want my cash back.

Risk and Businesses

In businesses, there are much more variables to consider.  But ultimately, do my businesses look more like hard assets or do they look like loans?

In terms of loans, they may pay income to compensate me for the time that I have advanced my money.  In terms of a business investment, the payments (beyond liquidating my investment) might be interest-like or dividends.

Where a business pays dividends, it is like an interest on loan but with less payment assurances (in preferred shares) over bonds/debentures to no guarantees (in common shares).  And when I choose, I might also have the ability of selling the investment to someone else.  It is just I maintain the risk of not being paid back in full.

Comparing Loans, Tangible Assets and Businesses

Accountants have a concept of payback where they measure how many years it takes before I have received back the full amount of the loan.  The lesser the number of years, the better. From a risk standpoint, a loan is superior to a hard asset in that I am paid through time and my net exposure decreases through time.

But in a hard asset, I am not compensated for time risk; however, there is a chance I might receive more than the purchase amount.

I might also have a chance of getting more back on a business that pays dividends.  The advantage is I potentially accept less time risk on a dividend payor in the process.  The odds of getting more than my purchase amount back is where I purchase at a discount – similar to a hard asset purchase.

It may be possible to make a hard asset look like a loan or business. For example, consider where you rent out your property.  Or where you write call options on your gold.  We just need to look at how that changes our risks and returns and how we can manage those risks - similarly by managing concentration and buying several different types of hard assets.

Diversification

With businesses, I wish to manage my risk by investing the same amount in 100 qualified businesses.  The main issues to diversify are the cost and time of finding and maintaining 100 qualified business investments.

Now the number of 100 was chosen as an example to show we can limit each loan or business to a 1% exposure.  So if an investment disappears, it costs us a palatable 1%. The number could be higher or lower, but this amount is influenced based on risk and return of each of the loans, hard assets or businesses.

Creating your own basket versus buying pre-selected baskets (like exchange traded funds or pooled investments like mutual funds) depends on a number of factors like your ability to assess investments, the ability of the managers in selecting the investments and managing risk, the time you have, the cost (like commissions to buy the investments and MER of a pool or fund), investment availability at the right price, the overall risk and net return of the baskets and constituent underlying investments.

Taxes

In looking at return, we must also consider the taxation as what matters at the end is how much of the interest, dividends and capital remains in your pocket. Taxation can greatly skew the investment decision.  Taxes can come in many forms (income tax, holding tax, capital gains tax and estate tax) and their rates may vary over time. And returns after taxation rarely if ever shows up anywhere as each person’s tax situation can differ greatly.

Anticipated and Unanticipated Needs

We also need to consider time.  Specifically, when do you need your money back.  So, if you think of someone retired that needs money every month to meet their living needs, we need to generate a cashflow that matches this cashflow need. As well, we need to factor in other lumpy needs over time. The better the matching, the lesser the portfolio risk in meeting your needs. In a mismatch, we might end up having to liquidate investments at low prices that can create permanent losses and possibly outliving your money.

And as stuff can happen to you, we must manage this risk of gaining access to funds sooner than planned or at amounts different than planned. That's why there is a rule of thumb of three to six month of cash needs in an emergency fund.

Investments Not Priced Rationally

Investments are not always priced rationally - actually, more often than not, their mispricing is a more common occurrence. And nobody knows how long the irrationality will go on for before prices correct. With mispriced investments, we think of it like an elastic band - the more mis-priced, the more the band is pulled. And we hope that the band will soon contract. But as nobody knows when - which could be years, we need many different investments and different asset classes. Having different asset classes; more specifically uncorrelated assets that move up and down differently, this hopefully will mean that something is up when we need to sell or to act opportunistically when something is way down.

Summary

Managing investments is an art. It is easy to look brilliant when the stock market is going up. And some people might show better returns than others out of luck as opposed to skill.  Generally every investor will be humbled at some point as investments move based on supply and demand behaviour that is generally not predictable in the short term.  

Given enough time, hopefully one’s ability over luck will emerge.  And in looking at and understanding one's methods of selection, you can assess if dealing with that investment manager is sheer madness or brilliance. I just hope to be more right than wrong, not cause any harm, and make my clients money providing for their needs throughout their lifetime.

ABOUT THE AUTHOR Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P. is a Senior Portfolio Manager with Lycos Asset Management Inc. – an independent investment management firm located in downtown Vancouver, BC, Canada. Steve focuses on building income portfolios to meet family retirement needs and provides financial planning so that if ‘life happens to you’, your goals aren’t derailed in the process. He has been in the investing and financial planning profession since 1992. Steve can be reached at 604-288-2083 Ext 2 or toll-free at 1-855-855-9267, or by email at steve@lycosasset.com.