Considering risk

By DAVID MOON, Moon Capital Management, LLC
August 9, 2009

One of the results of the stock market collapse that began in October 2007 is that it prompted many investors to seriously consider something which they had only previously given, at most, superficial attention: real risk.

When it comes to risk, investors have always talked a good, but shallow, game. It's usually dominated by phrases like "to earn greater returns, you must take greater risks" and "stocks are risky; bonds are conservative."

The last decade has thrown a monkey wrench into those schools of thought hasn't it?

Even with the Dow Jones Industrial Average's recent recovery above the 9,000 level, it still sits nearly 13 percent below where it did on July 31, 1999.

An investment made in U.S. government and high-grade corporate bonds in 1999 would be worth 80 percent more today.

So which underlying assumption is incorrect: that stocks are riskier than bonds? Or that you must make riskier investments to earn higher returns?

That depends on how you define risk. For many people, their definition has changed considerably in the past two years. Let's hope, however, that the definition you are using is forward-looking, not simply focused on recent history.

If your definition of risk focuses on recent history, you would assign degrees of risk based on an asset class. Stocks have declined significantly, so they must be riskier than bonds.

Using that logic, however, you might also conclude that Chevy Tahoes are more risky than GMC Yukons or Volkswagon Jettas based solely on the details of a single freak accident.

Some automobiles are inherently safer for their passengers than others. But to assess the risk of any specific driving situation, you must also consider a number of factors other than just how much the car weighs. What are the road conditions, skill of the driver and speed of the automobile?

Investing is the same.

In the event of a business failure, equity investments (stocks) have riskier qualities than bonds. In liquidation, bondholders get paid before the stockholders.

But there are other factors that affect riskiness as well.

Time. The closer you are to needing your capital, the more important is the volatility of the price of an investment. If you won’t need your money for many years, risk is mostly unrelated to price volatility – no matter what your advisor or finance professor says.

Leverage. An asset purchased with borrowed money is significantly more risky than the same asset purchased with cash.

Price. It matters what you pay for an asset - even a wonderful asset. Walmart may be the best company in the world, but if you pay 60 times earnings for the stock in 1999, there's a chance that ten years later your investment will have declined 25 percent - even if Walmart's earnings increase 165 percent in the meantime.

So which are riskier, stocks or bonds? That depends a lot on your time horizon and the prices of the stocks and bonds. With both interest rates and stock prices at multi-year lows, the obvious answer may not be the correct one.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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