Now is Not the Time for Risk

Yesterday I received a “query” from a writer for the Wall Street Journal’s online edition for information on a story. A “query” is typically sent out by a writer looking for an expert opinion. For this query the writer was asking for suggestions on ways that a near-retiree could add risk to their portfolio, in an effort to boost returns. The idea is that so many retirees have suffered such poor investment performance for years that soon to be retirees need to play a little “catch up.” My response was basically that that was one of the stupidest ideas I had ever heard! So assuming I won’t be quoted in that piece, and there is no reason to wait for the article to be published, let me share some thoughts on this subject.

Investors (and apparently financial writers at wsj.com) have been misled on what risk is, and how it affects portfolios, for years by the mutual fund industry and the financial planning community. The theory goes that by increasing the risk of a portfolio, the investor also increases their return. As if this is a foregone conclusion. But if that is the case than where is the risk? If by definition you change investments and you, by definition increase return, than there is no “risk.” So everyone would be stupid not to have “high risk” portfolios. Heck the more the better, let’s dial up a little more “risk.” Just turn up the heat on the oven and the bread will be done sooner. Right?

Last night I was watching Extreme Pawn Stars. If you haven’t seen the show, it’s about a pawn shop in Detroit. It offers entertainment on two levels, first it’s interesting to see the stuff that gets brought in, and second the characters that bring in the stuff! Last night, this guy brings in a Cabbage Patch® doll and wants $100 for it. The pawn shop owner asks him simply, “How did you come up with that number?” His answer, now pay attention here, was, “Because I’m being evicted and need $100.” The store owner offered him $10. The moral of the story is that neither the pawn shop owner, nor future buyers for the Cabbage Patch doll, really care that this guy needs $100. The just want to pay what the thing is actually worth. $10.

This made me think about the whole premise behind the query from the WSJ writer. Investors, for whatever reason, think there is a correlation between needing a higher return on their investments and actually getting a higher return on their investments. The fact is the “market” doesn’t really care that you, or any other investor actually needs anything. And just because an investor needs a high return does not mean that there is some dial that can be turned to turn up the returns as well. The sad truth is, neither owner of the pawn shop nor the market, really cares what anyone needs for their Cabbage Patch doll, or from their portfolio. Each is worth exactly what someone else is willing to pay for them. No more, no less. Personal circumstances just don’t matter.

I will go a step further and explain that this is the difference between the professional investor and the amateur. The amateur is always “long” or fully invested, expecting high returns, because they need those high returns. They typically take risks, at the wrong time. The professional understands that just because he or his clients need return, it is not always possible to get them.

I’ll close with a sad but true example. Almost exactly a year ago, my partner and I went out and made a proposal to manage a company’s pension plan. They had lost a lot of money in the plan and had to add $1 million from the company account to the pension plan. I recommended using our dividend value strategy. In a shaky economy dividends would add stability and provide cash flow to pay out benefits down the road. The owners were noticeably upset that they had lost a significant amount of money and had to now fund the losses. I thought this was a prudent strategy. Instead, the owners went another direction. Determined to “make up” their losses they went with a rather high risk/high return strategy (in their minds) choosing a “specialist” in small company stocks for their existing balance, and self-directing $1.4 million equally divided between Wells Fargo, Citi, and Bank of America. In their attempt to catch up, because they needed the return, they have lost probably another million dollars in 12 months. Instead of catching up, they will need to somehow find another $1 million from company coffers, in this economy, to fund their pension plan or risk penalties from the Department of Labor.

Turning up the heat on the oven is more likely to result in burned bread, instead of simply finishing it sooner. Similarly turning up portfolio risk is a good recipe for being burned as well. In baking and investing, patience is truly a virtue.

Advertisements

bill@401advisor.com • 937.434.1790

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Join 420 other followers

Follow me on Twitter

on Amazon

Link to my weekly column.

Charles H. Dow Award Winner 2008. The papers honored with this award have represented the richness and depth of technical analysis.

Archives


%d bloggers like this: