If you’ve heard it once, you’ve heard it a million times. Everyone 'knows' investors need to park their funds in low-risk funds and investments, or at least take risk into account. But what does risk in investing really entail?
When people mention low-risk investments, a commonly offered example is United States Treasuries. People point out that the U.S. has the largest economy in the world, and the power to print money to avoid default. Our monetary policy is well-insulated from politicians via the Federal Reserve. The dollar is the world's reserve currency, and we’ve never defaulted on our debt payments. So no risk, right?
Another characteristic pointed out is price volatility. If the price of a stock or bond tends to fluctuate less than the market as a whole, it is said to be ‘low-risk.’ Many investors equate sudden and major price shifts as increasing the likelihood of investing losses, and investors tend to prefer stability and certainty. Major price swings can cause investors to sell in a panic, or buy during periods of exuberance, which can lead to long-term pain and investment underperformance. In my opinion, these definitions are complete nonsense.
U.S. government debt can be highly risky. Most U.S. debt has fixed interest payments, so if inflation rises, the less you can buy with interest payments. If interest rates rise, demand for your T-bills will likely fall, driving the price down and potentially resulting in a capital loss. Fluctuating interest rates can mean investors can’t reinvest in government debt at the same rates as their current bonds reach maturity. Certainly not ‘risk-free’ in my opinion.
As for volatility? If you don’t need the funds you have invested in the stock market for the next several years, volatility should mean nothing to you. In fact, many successful investors embrace market volatility, as it gives them the opportunity to purchase shares at a discount to their underlying value. Price upswings in frothy markets can present an opportunity to sell at a tidy profit. To be sure, specific companies can be volatile for reasons to make you steer clear. It’s tough in the short term to watch your portfolio swing in a negative direction. But volatility is not inherently risky, just make sure you have a steady temperament and time for your portfolio to recover.
What does risk mean with investments? For me, it boils down to the chance of permanent capital loss. If you don’t use leverage in your investments, a permanent decline in the value of an investment or portfolio is the worst thing that can happen. We invest to have our hard-earned money make money over time, right? What then are some of the warning signs that you have a risky investment?
First, the company in question has poor or negative cash flow. A company’s reported earnings can be manipulated and not representative of economic reality. Much like individuals, when a company runs out of cash, things can go sideways quickly. A company that generates free cash flow over time is a company that can weather more storms.
Second, management does a poor job of deploying the capital it receives. Shareholders look to management to use capital in a way that increases value. If metrics such as return on assets, return on equity and return on invested capital are low enough, it risks a selloff and ruining the reputation of the company you are invested in.
Risk factors can also be found on the company’s balance sheet. If debt levels are unsustainably high compared to cash and equity, that increases the risk of default, and a company’s share price can take a permanent hit. A company's balance sheet is a useful place to search out potential financial landmines that could explode in the short term or long term.
This is not an exhaustive list. There is more to say on the topics above, and there are numerous other risk factors for any company that can result in a permanent loss of capital. But for the sake of brevity, I’ll leave it there.
Risk is a word that is frequently thrown around on the topic of investments, and it’s an important subject. The most common example of risk-free investing is U.S. T-bills, due to minimal default risk, the Federal Reserve. Risk is frequently defined as volatility, which assumes the lower the price fluctuations, the lower the risk. There is plenty of risk in U.S. Treasuries and volatility in stocks is not a risk factor with the right temperament and timeframe. Rather, investors should look to the possibility of permanent capital loss with each investment they make. Cash flow, management deployment of company resources, and the health of company balance sheets are some of the primary risk factors present in an investment.
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