By DAVID MOON, Moon Capital Management, LLC
February 23, 2014
One of the most talked about and least understood topics in finance is risk. To paraphrase Mark Twain’s observation about the weather, everyone talks about risk but, with the exception of Al Gore, no one does anything about it.
The conventional professional wisdom about risk is misleading, conflicting and often counterproductive.
Since your first day as a participant in a 401(k) plan, you heard that you must take more risk if you want to earn higher returns. Intuitively, that seemed to make sense.
But if a riskier investment provided greater returns, it wouldn't be a riskier investment, would it?
The paradox of risk.
The management of risk is one of the most important determinants of your long-term investment success, yet neither the investment advisory industry nor the academic community does much to really help you.
If you are considering investing in a 1-year bank CD or JC Penny common stock, you intuitively sense that the bank CD is less risky. But the bank CD is guaranteed to lose ground to inflation; the JCP stock has some possible chance of providing a real, inflation-adjusted return.
What if the stock was Johnson and Johnson instead of JC Penny? Over the next five years JNJ stock is highly likely to outperform inflation, while the CD is guaranteed not to. Which of those investments is less risky?
Using traditional investment theory, too many consultants would automatically classify the JNJ stock as more risky than the CD, based solely on the expected daily fluctuations in the stock price. Traditional investment theory ignores that the underlying value (not the price) of JNJ stock doesn't fluctuate much at all over the course of a quarter, much less a week or day.
Consultants believe that volatility is risk, regardless of an investor’s situation or goals.
A person's specific situation affects the riskiness of an investment. A major type of risk is not achieving your goal.
A retiree who is spending three or four percent of his assets every year cannot afford a portfolio of long-term investments that will almost certainly outpace inflation, but may also fluctuate wildly in price.
A young person, accumulating money each year in anticipation of retiring in 30 years can’t afford not to buy that same investment.
If your goal is to beat inflation, a short-term CD or treasury bill is a very risky investment.
An investment can be either risky or conservative based on the price at which the asset is offered. A Gay Street condo selling for $600 per square foot is much riskier than the same condo selling for $200 per square foot.
Price volatility is risky for people withdrawing money from their investments, but irrelevant to long-term investors. Long term investors can deal with illiquidity of their assets.
Your debt impacts the riskiness of your investment. A leveraged investor is similar to a retiree. Because of carrying cost, the clock becomes his enemy.
Remember, while risk can be assessed, it cannot be calculated.
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).