Given the turmoil in the stock market, and the shutting down of six debt schemes of Franklin Templeton Mutual Fund, the concept of risk has once again gripped investors.
When I think risk, I think Allison Schrager. She is an economist like no other.
After I heard her interview with Barry Ritholtz, I immediately purchased An Economist Walks Into A Brothel, and had my fan girl moment when she visited India.
To understand risk, she approaches the real experts; the ones whose careers require them to take risks day in and day out. With an economist’s analytic framework, she has derived a brilliant understanding of risk from prostitutes, gamblers, paparazzi and big-wave surfers. “Unusual markets often provide the clearest insight into how risk is assessed, bought, and sold,” is how she put it.
I am going to attempt to put down a few insights of hers, based on my reading of her book and articles, and listening to her interviews.
While most people view retirement as accumulating income, managing losses and maximizing the pile of money, she believes that the real goal is to have predictable income in retirement. To get there, you will have to deal with different sources of risk: the risk that the stock market will crash, the risk that you will outlive your money, the risk of interest rates falling, the risk that you will need to finance a serious health event, and so on and so forth.
How do you deal with this risk? First, by understanding it.
Idiosyncratic Risk and Systemic Risk
Idiosyncratic risk is unique to an individual asset. For example, a company stock price may get severely hit due to a plant closure. Or, the change in management would leave the future of the company unclear. This would affect the stock price of the company in question, not the prices of other stocks in the very same sector.
Systemic risk affects the larger system. Every stock rises or falls because the entire market rises or surges, as it did in 2008. It happens due to a big economic disruption (war, recession, election result) that people think will impact business.
The pandemic and the subsequent lockdown it triggered, has pushed the global economy into a recession of uncertain magnitude and duration. This is morphing into a full-scale systemic crisis.
These are harder to manage since the downsides are potentially more dangerous. If the entire stock market tanks, you risk losing your job and stock portfolio at the same time. Or, the entire stock market crashing the day you are set to retire.
(There is a difference between systemic risk and systematic risk, which you can read here. But for the sake of simplicity, I shall just talk about systemic risks).
How do we tackle these risks?
Diversification and Hedging.
- Diversification is a powerful risk reduction tool. You can diversify to eliminate idiosyncratic risk.
Diversification eliminates unnecessary risk by owning shares across the spectrum. Your expected return is the same, but risk is reduced, because no matter what happens, odds are something you own will pay off.
Let’s time travel back to January 1993. You have $25,000 to invest for 20 years.
Both, Apple and Hewlett-Packard are established companies in the tech sector, both look promising, and each have returned an average 11% per annum.
Twenty years later, if all the money found its way into the Apple stock, it would be worth more than $1 million, but only $57,000 in HP. In hindsight, Apple was the better bet. But in 1993, it was impossible to figure that out. Apple’s prospects were not great and the iPhone was not even on the horizon. Apple’s stock went down more than 75% after 1993, before it took off.
In hindsight, the best bet would have been to equally invest in both stocks. In such a situation, you would have $604,000 in 20 years – much less than if you had just invested in Apple, but considering what you knew in 1993, chances are you would have skipped it altogether.
You can reduce risk even more by buying stock in a completely unrelated industry. For instance, a meltdown in technology will not impact the auto industry much.
When investing for retirement, you may choose mutual funds and a collection of stocks, instead of a single stock. This is not a complete retirement investment strategy since these funds offer only diversification. A more complete strategy hedges the remaining risk.
- Hedging means de-risking.
Hedging is determining how much of that risky option you want to or have to take to achieve your goal. It comes at a cost. You must give up some of your expected gains, because you are taking less risk at the cost of less reward.
This is de-risking; giving up potential gains if things go well, in exchange for reducing the odds of things going wrong. So you take less risk and give up some potential good returns in exchange for reducing the risk of loss.
For instance, let’s say an individual has $12,000 today and wants $15,000 in 5 years. A stock portfolio returning 8% per annum should amount to $17,600. But no guarantees there. Let’s say the stock market drops 40% in the first year. Even if it returns 8% each of the next four years, by the end if the fifth year you will have about $9,800.
Instead, if you put $6,000 in bonds (3%) and the balance in stocks (estimated 8%), your expected return will be 5.5% a year. Lower than 8%, but odds are that you will have around $15,000 in 5 years. If the stock market drops in the first year and then recovers, you end up with $12,000. Hedging relieves some of the risk of losing money, in exchange for giving up the possibility of that extra $2,600.
How to implement the above
- If you invest in equity (and you should when saving for retirement), you can eliminate lots of unnecessary risk by spreading money in many stocks or mutual funds, instead of just a few.
- Don’t stop at diversification; it is only the first step in a smart financial strategy.
- Hedging involves balancing your exposure in stocks by investing in low risk assets, like bonds. This is also how pension funds de-risk.
- Maintaining the right balance right requires upkeep: you will need to reshuffle allocations between stocks and bonds depending on which asset class has grown disproportionately.
By combining diversification and hedging, you mitigate portfolio risk and improve portfolio efficiency. The future is always unknowable, and planning is often futile. But if you devise a risk strategy and stick with it, you will be better prepared to handle whatever comes.
Let me end with a quote of Allison's: Knowing what you want might be the hardest part of risk management. A realisation that only recently dawned upon me.
Investment Involves Risk of Loss
