A Rich Life

The Old Ideas on Saving & Investing Don't Work -- Here's What Does

Podcast #167 — Risk Is Never, Never, Never Good

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I’ve posted Podcast #167 to the “RobCasts” section of the site. It’s called Risk Is Never, Never, Never Good.

Have you heard the one about how it’s always good to take on more risk because taking on more risk is guaranteed to lead you to enjoying higher returns?

Comments

  1. Have you heard the one about how it’s always good to take on more risk because taking on more risk is guaranteed to lead you to enjoying higher returns?

    No, I have never heard such a comment from anyone who understands investing.

    Here is William Bernstein on the subject.

    Now we arrive at one of the most counterintuitive points in all of finance. It is so counterintuitive, in fact, that even many professional investors have trouble understanding it. To wit: Since Kmart is a much riskier company than Wal-Mart, investors expect a higher return from Kmart than they do from Wal-Mart. Think about it. If Kmart had the same expected return as Wal-Mart, no one would buy it! So its price falls to the point where its expected return exceeds Wal-Mart’s by a wide enough margin so that investors finally are induced to buy its shares. The key word here is expected, as opposed to guaranteed. Kmart has a higher expected return than Wal-Mart. But this because there is great risk that this may not happen. The proper way to look at a stock like Kmart is as follows: There is a high likelihood, say 75%, that it will not emerge from Chapter 11, and that its stock will become worthless. If, on the other hand, it recovers its earnings capacity, its price will rise greatly—say by a factor of eight. So Kmart’s expected return is (75% x 0) plus (25% x 8) minus one, or a 100% gain. In other words, its stock has acquired the characteristics of a lottery ticket.

  3. I give an example of the problem in the podcast, Evidence.

    There are lots of people who in the late 1990s were behind on their retirement planning efforts. They asked the “experts” for help. One of the tips that was put forward at the time was that those who were behind should take on more risk. That is, they should go with higher stock allocations.

    At the top of the bubble, the most likely ten-year return on stocks was a negative 1 percent real per year, according to the historical data. The guaranteed return on TIPS was a positive 4 percent real per year. That’s a difference of 5 percentage points of return every year for 10 years running. Do the math and you see that the retiree who followed the advice of the “experts” ends up down by 50 percent.

    A good thing? Or a bad thing?

    My take is that any investing “theory” that causes retirees who are already worried about being behind to fall much further behind is an investment “theory” that needs to be reexamined.

    The answer for those who are behind is to obtain more return with LESS risk. That’s Valuation-Informed Indexing. Taking on more risk because you are behind is INSANE. That’s like a poker player who doubles up on his bets because he is running out of money. That’s called “shooting the moon.” It’s reckless. Taking on more risk leads in the long term to taking on more losses. Losses are bad. You want gains, not losses.

    The root problem is that Passive Investing is a “strategy” rooted in emotion. People are being told to take on more risk because that is what feels good at the top of an insane bull market. It is the opposite of what works. Rational Investing (taking on only risks that are likely to generate better returns) is what works.

    That’s Rob Bennett’s take, in any event. Many of the biggest names in the field offer a very different take, to be sure. People should listen to both sides of the story and make up their own minds as to what to do with their own money.

    Rob

  4. The quote above is from The Four Pillars of Investing: Chapter 1. No Guts, No Glory:

    Thanks for providing the link, Evidence. You are helping us all by giving us something to think about and by being thorough enough to also supply a link that offers background. Bernstein is one of the best out there. I believe that you and I are in agreement re that one.

    Rob

  5. The answer for those who are behind is to obtain more return with LESS risk. That’s Valuation-Informed Indexing.

    Again Bernstein on the subject.

    The Intelligent Asset Allocator – Chapter 1: General Considerations

    You have just been introduced to one of the fundamental laws of investing: in the long run you are compensated for bearing risk. Conversely, if you seek safety, your returns will be low. Experienced investors understand that reward and risk are inextricably intertwined; one of the most reliable ways to spot investment fraud is the promise of excessive returns with low risk.

  6. in the long run you are compensated for bearing risk.

    The entire point of Podcast #167 is to challenge this claim, Evidence.

    William Bernstein is a smart fellow. Do you think he is God? Do you think he is incapable of getting something wrong?

    I think he is a smart fellow. I also think he is capable of getting something wrong. My take is that he is another one of those wonderful and yet flawed humans, nothing more and nothing less.

    Rob

  7. one of the most reliable ways to spot investment fraud is the promise of excessive returns with low risk.

    My take is that one of the most reliable ways to spot investment “fraud” is the promise that this time it will all be different, that for the first time in history the price you pay for stocks will not make a difference in the long run.

    Stocks were insanely overpriced from January 1996 through October 2008. People like Bernstein should have been warning people about the risks of failing to lower their stock allocations. He should have been warning people to avoid Passive Investing, not to embrace it.

    I’ve learned lots of great stuff from Bernstein. He is one of my heroes. But I believe strongly that he made a tragic mistake in failing to speak up in the strongest possible terms re the recklessness of the Passive Investing “idea.” I believe that all investors should read Bernstein and learn from the stuff he gets right. I also believe that all should be wary of the stuff he says that just does not make sense or that just does not stand up to informed scrutiny.

    The reality (according to the historical data) is that risk is sometimes rewarded and sometimes not. The key to effective investing is knowing what risks are worth taking on and what risks should be avoided at all costs. Staying at the same stock allocation when stocks reach the price levels that applied during the insane bull market is a risk that all investors should avoid at all costs, in my assessment.

    Rob

  8. in the long run you are compensated for bearing risk.

    The entire point of Podcast #167 is to challenge this claim, Evidence.

    You know that the compensation is not guaranteed. The only explanation I can come up with is that you are choosing not to make use of this knowledge.
    Instead you construct a straw-man argument, “The experts say risk guarantees reward”, to give yourself something to rail against in this podcast.It does not seem to me to be a constructive use of your time to spend all this time challenging an argument that was never made.

  9. The reality (according to the historical data) is that risk is sometimes rewarded and sometimes not.

    Exactly, hence Bernstein’s comment that “The key word here is expected, as opposed to guaranteed.”

  10. hence Bernstein’s comment that “The key word here is expected, as opposed to guaranteed.”

    Imagine a world in which the medical industry owned the tobacco companies. So every doctor came to understand that he could enjoy great riches if only he could persuade his patients to smoke three packs of cigarettes each day. Your doctor tells you that the best thing to do for your long-term health is to be sure to smoke three packs per day but adds in a footnote that of course there is no absolute guarantee that this will work in every case. You die 20 years sooner than you would have died had you followed your common sense.

    Was the advice given good advice?

    I say “no.”

    True “expertise” is expertise that helps people get the odds on their side. Passive Investing does just the opposite. The fact that most Passive Investing advocates note in a footnote that there are cases in which the advice they offer doesn’t work out doesn’t impress me. Good advice is advice that stands a good chance of working out.

    Risk is bad. People should not be seeking it out. In some cases it might make sense to take on some added risk because it appears that there is likely to be a long-term payoff. Staying at the same stock allocation at times when stock prices go to insanely dangerous levels is not one of those times, in my assessment.

    Taking on insane risks is rarely compensated in the long run. Staying at the same stock allocation when prices reaches the levels that applied from 1996 through 2008 was taking on insane risks. We should be telling people to avoid Passive Investing, not to embrace it.

    Rob

  11. You are the king of bad analogies. I thought your drunk driving analogies were bad but I think you have outdone yourself with this smoking analogy.

    Risk is bad. People should not be seeking it out.

    Those people who do not have the stomach for it should certainly not be seeking out risk.
    However those who understand investing and can stomach the risk should take note of Bernstein’s words “Assets with higher returns invariably carry with them stomach-churning risk, and safe assets almost always have lower returns.”

  12. Thanks again for your contributions, Evidence. You’ve added some much-needed balance to the discussions held here.

    Rob