There is a chance you do not earn the profit you predict, you may lose all your money, or you may end up needing more than expected. These risks come from many causes but apply to every investment you make, no matter how basic. In all cases investors demand compensation for assuming risk, or else everyone would invest only in 'safe' investments. That compensation is usually the expectation of higher returns. It can also be the reduction of another type of risk. It can also be the love of your family, when they need financial help.
You need not compute complicated equations or look up meaningless metrics, but you must explicitly recognize and heuristically evaluate all risks before you invest. Too often people simply ignore the possibility of bad outcomes that are obvious from the start. It is far better to assume the worst, rather than assume the best.
Money is always flowing between markets. The changing risk of one type of asset will effect the market prices (and risk premium) of other asset types. You must always evaluate the 'relative' attractiveness of an asset given its risk. An example of this effect was in 2008 when the economic risk of all businesses all around the world exploded in the 'credit crunch'. The 'flight to safety' resulted in the price of US treasuries rising sharply, even though their own risk profile had not improved (and actually worsened).
Instead of working from an evaluation of risk toward determining the appropriate return, retail investors often reverse the process. They judge an investment by its expected return. They think large dividends and low P/E's mean the investment is a good one. In fact, these metrics indicate the investment is NOT a good one; that there are some impending problems; that markets are demanding extra returns for assuming that risk.
The reason so many retail investors make that mistake is because it is far LESS WORK to find a widely quoted, single, objective number like the yield, than it is to properly research an investment. It should be, but isn't, obvious that investing is far more difficult than ranking companies by one, single metric. If you do not want the bother of researching investments, please just admit it. You can buy index ETFs and do as well as the market, and probably better than all your stock picking friends.
For each of the following types of risks, you should understand their cause and effect; how they are measured; and how they are hedged.
REPAYMENT RISK (default risk, capital risk)
Most investments involve giving your money to someone else to do something with. You always run the risk that they abscond with your money, or that they go bust and cannot repay it. The US government is considered to have the lowest repayment risk, assuming they have the power to tax their subjects. Foreign governments are much more likely to default. They may even earn political points at home for doing so.
Businesses with majority owners pose the largest risk of default when things go wrong. The insiders will know, well ahead of public investors, when to start worrying. There are many, quite legal ways for them to recover their own money, leaving the company shell to the public. Once a business officially goes broke, laws determine who gets paid first. The tax man and employees rank high on this list. Debt holders come next, then Preferred Share owners. Equity owners come last, with the most risk of getting nothing.
Credit bureau's exist to measure the probability of default for specific debt securities. They cover bonds, debentures, preferred shares and income trust units. They usually have access to more information than the retail investor, so their ratings should be consulted. Be clear that they rate only the probability of default, not the risk of price volatility. A security may lose value temporarily because of market sentiment - sentiment that may not be correct in the longer term. As the ABCP crisis has shown, the rating agencies can be co-opted by the businesses whose products they rate, because they are paid by those same businesses. The rating of each security signals to the market what interest rate its issuer should pay. See this website for US bond spreads for each rating.
Regulators sometimes provide insurance to cover default risk. American (FDIC) and Canadian (CDIC) regulators insure cash in bank accounts (to a limit). Both countries have another plan to insure your securities held by brokerages. Note that this does not insure the value of those securities. It insures that the brokerage will not walk away with your 'ownership certificates'.
Sometimes investors can buy insurance to protect their invested capital. E.g. real estate is frequently insured by owners. Its small cost is a good trade off against the value lost in a fire. 'Counterparty risk' refers to the risk that the party on the other side of the derivative trade (e.g. insurance) cannot pay the claims they contracted to cover. The insurance you buy, is only as good as the reliability of the insurer to pay claims. During the 2008 credit crisis, it turned out that institutions were buying insurance (credit default swaps) from companies that could not pay the claim.
Principal Protected Notes (PPN) are a product offered by banks and insurance companies that allow you to participate (to an extent) in the risky stock markets while your initial investment is guaranteed to be repaid in (say) five or ten years. You must weigh the cost of the insurance against the default risk. Say the PPN allows only a 50 percent participation in the market return.
Another way to analyze the cost is to compare
- The cost of PPN's insurance is the value of the stock returns you give up. If you think the stock market will return about 10%, then the insurance is costing you 5% each year.
- Contrast that against the probability that the stock market will have dropped after a
5 year period (historically 11 times over 80 years) or
10 year period (historically 2 times over 75 years).
See the graph on Sheet 8 of this Excel file.
In 30 of the 42 5-year periods, the T-bill return was higher than 1/2 S&P's return. (Sheet 5 of the same Excel file).
- the expected return from T-bills of the US government (approximating inflation) to
- the half of the S&P's expected return (after tax for both choices).
When used by academics or finance industry people, the term 'risk' almost always refers to the volatility (or variability) of the investment's price (of its rate of return really). This is the sense in which the term 'risk-reward tradeoff' was coined. E.g. The yearly return from a US bond (safe) will fall within 8.3 percentage points above and below the average 4.8% return, 2/3 of the time. The yearly return from a US stock (risky) will fall within 19.9 percentage points above and below the average 10.1% return, 2/3 of the time.
Notice that the width of possible returns includes both the upside as well as the downside. Both are considered equally bad. Standard deviation (SD) is its mathematical measure. The math is based on a presumption that the probability of returns follow a 'normal curve' (remember the Bell-curve for school grades?). US equity returns show that kind of history. But other countries' equity returns have had outlier results that are more extreme than predicted by a 'normal curve'. They are said to have a 'fat tail'.
The risk-return trade-off gets turned on its head in bear markets. The expected monthly returns are 2 percentage points lower than expected in a bull market, while the standard deviation is 50 percent greater. Of course you would have to identify the bear market in real time to change your behavior. This difference in risk may well explain why active managers argue it is much easier to outperform passive indexing in bear markets. Bull markets are a steady plod up the wall-of-worry, but bear markets have sudden and violent drops.
The risk-return trade-off also gets turned on its head when measuring actual returns within the asset class of common stocks. This is called 'the low-volatility anomaly'. Numerous studies have shown that stocks with lower price volatility have generated higher (not lower) returns for investors. There are a number of ideas why this happens.
- It could be a 'lottery effect' where people will over-pay for a big payoff. Those with small portfolios have been shown to evidence this attitude toward risk.
- It could be that most investors do not have access to leverage to get the high level of risk they are willing to accept, and so pay more for high-volatility stocks.
- It may be that institutional money managers' compensation schemes promote risk-taking with large bonuses for excess returns.
- It could be that the market is inefficient. Investors may interpret the statistics to think they will get higher returns when they buy riskier stocks, so they are willing to pay more to purchase them - putting the cart before the horse.
- The results might only be measuring a predicted math effect, if you think prices grow arithmetically (which they don't, of course, because Betas change). When the market's volatility is high enough, the cumulative return for a portfolio with a Beta greater than 1 will be less than the market portfolio's.
Risky stocks are supposed to frighten you into using a larger discount rate --- in other words you are supposed to pay less for them, pay a lower valuation. Your profit is determined by the price you pay. When you pay less your profit is higher. Risky stocks seduce the market into paying higher valuations because they have media coverage and become 'market darling'. What happens is the exact opposite of what is supposed to happen.
There are even more problems with the concept of a risk-return trade-off. Between asset classes Beta seems to explain different returns - in the long run. But between 1980 and 2012 (more than 30 years), as interest rates fell from double-digit to miniscule, returns from low-risk treasury bonds have outperformed risky stocks. All along the way, stock investors told themselves "interest rates cannot possibly go lower" but they did. The risk-return trade off is only in effect at t=0. Expectations do not always pan out.
But high standard deviation is not necessarily bad if an investment’s average return is high - if you get paid for assuming the risk. The Sharpe ratio measures excess return per unit of risk (as measured by SD). Another metric that measures a risk-adjusted return is the Coefficient of Variation. It measures risk per unit of return - SD divided by the mean rate of return. The lower this number is, the less risk per unit of return.
Standard Deviation also does not distinguish between upside and downside volatility. Investors have a problem ONLY with underperformance. The Sortino ratio is a modification of the Sharpe ratio that only penalizes an investment for downside deviation. Academics keep working. There is now a risk metric called 'chi' that measures the down-side-tail of a stock's distribution curve vs. the down-side-tail of a benchmark. A low metric indicates lower probabilities of negative returns, and lower down-side risk, but also seems to predict higher nominal returns - the exact opposite of the high-risk, high-return doctrine.
A problem with the older metrics is the buried presumption. The context in which you hear them used is most often an attempt to dismiss someone's exceptional portfolio returns. "Oh sure, you outperformed the benchmark by 10%, but on a risk-adjusted basis you actually UNDERperformed". The presumption in that statement is that the additional volatility was unacceptable. But who says? The volatility may well have fallen within the owners' tolerance.
The use of these risk-adjusted metrics is valid only if the investor changes his asset allocation according to the risk of his securities. If the investor has already decided on (say) 50:50 debt:equity, and will not change that AA no matter how risky his choice of securities within that equity allocation, then a metric that 'normalizes' returns serve no purpose. Most retail investors won't change their AA. The use of these metrics assumes that AA is determined after the risks of the individual securities is considered - a higher allocation to equity if the securities are lower risk, and vice versa.
Volatility impacts the investor in five ways.
Investors react emotionally to swings in market prices. It is emotionally hard to NOT sell an investment that has lost value - you just cannot tolerate any deeper losses. The result is an emotional toll, as well as a possible loss of returns from selling at the bottom. Buying a basket of different stocks/bonds allows the volatility of one's upswing to offset the other's downswing. In total your portfolio suffers less volatility and is easier, emotionally, to maintain. How many different securities you need to get rid of the individual security's risk is not agreed. 20 used to be the recommended number but it has increased. Some say you now need 50 securities because securities now move more closely in tandem. ( e.g. W. Bernstein) Of course you will still be left with the volatility inherent in the asset class itself.
You can get rid of even more volatility by diversifying your portfolio's asset classes - traditionally between stocks and bonds. Now real estate, commodities, etc are added to the mix of asset classes. Portfolio theory claims that you can add asset classes with lower expected returns without lowering the expected return of the portfolio, even as the addition lowers the portfolio's volatility. This is all proven with dense math and backtesting. The Efficient Frontier is the best trade off you can get - the highest portfolio return for any given volatility. Many portfolios will lie below the line. But remember that this line is an average of historical returns. Individual decades have produced radically different looking charts. See also the warnings on the Backtesting page.
The measure of how closely a individual stock's returns tracks that of the equities class is called the 'beta coefficient'. The stock with a beta coefficient larger than one (or negative one) is riskier because its price swings wider than the asset class does. A beta between one and negative one means the volatility is less than the asset class. A negative beta coefficient means the asset's price moves in the opposite direction to the market.
Since investors demand extra returns for assuming risk, they should incorporate beta into the discount rate used to value a specific company. Say 10-yr T-bonds yield 5% and you demand 9% from equity investments. The equity risk premium would be (9% - 5% =) 4%. If a stock's beta is (say) 1.3, you can calculate a premium specific to the company equal to (4% * 1.3 =) 5.2%. The discount rate you would use equals the sum of the T-bond rate plus the specific equity risk premium (5% + 5.2% =) 10.2%.
You can find a stock's beta on the Yahoo Finance site in the "Key Statistics" link, on the right under the heading "Trading Info". You can also calculate Beta yourself using this spreadsheet's longer tracking period.
One way to protect yourself from volatility is called 'dollar cost averaging'. When buying into any position, you can divvy-up the cash into equal-dollar, multiple purchases over time. Each dollar will buy more shares when the price is low, and less when the price is high. Your resulting cost-per-unit will be higher if the market price marches upward, because you delayed the purchases, but lower if the price declines or is merely volatile around a flat line. The reality is that most people are enticed into the markets, or into a stock, after it has done well. In other words, they buy at the top (and sell at the bottom). Dollar-cost averaging will save you from this error.
The second reason to care about volatility is because many investors have a need to liquidate the investment at a specific time - e.g. to pay for college in 2 years. It is impossible to know in advance whether the security will be at its high price at that time, or at its low price. If cashed out at it's low point, that loss gets crystallized, permanently damaging the portfolio's value.
You can control this risk by choosing products with a certain cash flow. E.g. A bond ladder is set up so there are sufficient bonds maturing in each year to fund a retiree's draws. The investor does not fret about any price fluctuation during the bond's life because it is irrelevant. The redemption value at the time it will be needed is know in advance. That is all that matters.
The third reason to care about volatility is because may people invest to create a nestegg for retirement. "Will I have enough?" depends on the variable yearly returns your portfolio generates - which cannot be predicted. There is a common argument that volatility decreases as you expand the time horizon - that returns will even out or cancel out, over time.
The chart above is from Jeremy Siegel's "Stocks for the Long Run". It measures the variability of the AVERAGE return for the holding period. It shows that the longer the time span, the lower the variability - even for common stocks. This is very persuasive, but wrong. It measures the wrong attribute. a) Its measure is a math calculation in hind sight, but the investor must still suffer the anguish of price swings in real time. b) What really matters is the variability of the ending portfolio's size - its cumulative return.
In fact time INCREASES the variability of the final portfolio's value, as shown in the graph above. The spread of possible ending values gets larger and larger. Each different ending valuation represents the result of one distinct AVERAGE rate of return over the period. The ideas and graph here come from John Norstad. He admits that the distribution may not be quite so wide if the markets revert to the mean and show cyclicality of returns. (This is a pro-forma graph not actual historical results). The US experience has shown this, but it is not universal. When international stock indexes are added to the data, there is no reversion to the mean, or reduction of risk over longer periods of time (Philippe Jorion).
Notice how the graph has no results in negative territory. Its author presumed that once the principal is lost it is gone for good and that is the end of the story. But what if the investor uses leverage? What if the investor rebalances from debt securities regularly? Then the results would indeed flow into negative territory - giving an even wider final distribution.
But wait. Things get worse. (The following is from a paper in the Journal of Financial Planning Aug 2010, by Chittenden, Moon and Toles.) Norstad's graph above reflects the resulting value of a lump-sum $$ amount invested at the beginning of the period. When a lump-sum investment is modeled, the sequence of returns experienced in each particular year does not matter. You can see why from the math discussed at Rates of Return. The following 20 year chart shows the value of $1 invested at the actual historical return for each year vs. its value if the path of returns was exactly reversed. Both values end up at the same place.
But in real life, savings are added each year to grow the portfolio - you need to model an annuity. (The flip side of this same issue is that withdrawals are staggered throughout retirement as the portfolio shrinks.) Now the sequence of yearly returns DOES make a difference.
The larger the volatility of yearly returns, the more important the sequence of returns becomes - the wider the range of possible final outcomes - even though all scenarios would report THE EXACT SAME AVERAGE ANNUAL RETURN for the period. The following chart shows the distribution of possible results from all the possible permutations of sequences of returns - 20 years of $12,000 savings (equaling $240,000 total) invested to earn an averaged 8.2% in stocks.
Each single point from Norstad's distribution of final values, will itself be a distribution of possible values when savings are added gradually and the sequence of returns is unknown. The distribution of terminal values results from the volatility of yearly returns. The width of the curve is narrower for debt - wider for stocks. And a portfolio of mixed debt and equity is in-between.
The historical experience in the US markets falls within those expectations. The 20 year annuity terminal values range between $500,000 and $1,500,000 with an abnormal spike to $2,000,000. The 30 year annuities end up roughly the same. In both time frames the range of outcomes varies by a factor of three or four. The risks did not decrease with a longer time frame.
The less cyclical Canadian stock index has resulted in far less volatility in terminal values. The graph above comes from Sheets 24 and 25 of the data spreadsheet. Investors have no control at all over the specific sequence of returns the economy will produce in their lifetime. No matter how well they invest, their returns will be greatly determined by the overall market. Some generations do well, and others don't.
The fourth reason to care about volatility ... Instead of looking at volatility in a negative light you can see it as presenting opportunity. Your investment returns come mostly from the difference between the purchase and sale price. Volatility presents opportunities to buy cheaply and sell when overpriced. Exactly what you want. Of course the glass-half-empty crowd will call this 'price risk' - the risk of paying too much.
Remember that volatility measures both the downside and the upside. You WANT upside volatility - you want capital gains. The pro-dividend crowd uses the lower volatility of dividend stocks as a selling point. Don't be overly impressed. When there are no dividends, the investor relies on price appreciation for ALL his profits. He WANTS a stock price that moves more than the general index.
- The fifth reason to care about volatility ... It can be traded for a profit. The VIX index measures the expected future volatility of the S&P index. There are futures contracts on that index. And there are ETFs and ETNs following the futures. This should not be attempted without a high level of knowledge, but for a start Cooper (2013) has some good ideas, and presents an understandable overview.
Market economies tend toward a cyclical boom/bust, as they correct, then overshoot, then correct again. Investors must know where they are in the cycle. They need to listen to the economists and central bankers and keep track of interest rates and inflation. This is required - sorry. Understanding business cycles and how they work is a prerequisite to effective saving and investing.
Business cycle theory says that as the economy heats up, business profits increase and their stocks rise. The reverse happens in the bond market. As companies borrow money to expand capacity they compete for capital, pushing up interest rates. When rates increase, the value of pre-existing bonds falls.
Unfortunately this negative correlation between debt and equity does not always hold true. For example, during the 1990's corporate earnings and stock prices increased with global affluence. But interest rates never increased because savings from the developing world flowed in to finance the US expansion - keeping rates low. This was called "the Great Moderation".
Also, the expected negative correlation between debt and equity may not hold true in truly bad times. Bond values also fall when the business's ability to repay the principal becomes questionable. In bad times when profits and stocks are falling, the debt may also fall in value due to insolvency worries ... in spite of the government cutting interest rates.
Never-the-less, some assets gain value in a booming economy (equity). Others gain value in economic contractions (debt). Some assets rise in value with inflation (real estate supposedly, and commodities). Other assets lose value with unexpected inflation (debt, utilities). Investors can reduce the risk of being whipsawed by business cycles by holding different asset classes. This is called 'asset allocation'.
The correlation between the returns of different asset classes is measured by the correlation coefficient for each pair. A coefficient of 1 (one) means that an x% increase in class A will happen at the same time as the same x% increase in class B. A coefficient of <1> (negative one) means that class B will fall by the same x%. Most asset classes fall between these extremes. Asset allocation is still worthwhile, even when positively correlated, because different classes with have different returns in different years, thereby smoothing portfolio returns.
Advisors will have you think that the asset allocation decision will make or break your investing success. But as you can see from this list of risks, asset allocation is just one of many risks you have to manage. If you care to read this, here is the seminal academic paper on Portfolio Selection by Markowitz (1959)
'Diversification' is the term used for buying baskets of securities within each asset class. It reduces the risk of individual investments the same way 'asset allocation' reduces the risk of single asset classes. Your total return is a blend of each component's return. It is easier to ignore the price swings of one investment if the portfolio, in total, has steady values.
- You allocate between asset classes to reduce the volatility of business cycles. In spite of cycling, the global trend is up. So you hold all asset classes for the long term, through the troughs.
- You diversify between countries for exposure to different types of economies. E.g. Russia is tied to oil, and Japan to manufacturing. View these series of 60 year graphs of stock returns from different countries. Also read this paper on comparative returns from country diversification. See also 'Political Risk' below.
- You diversify between industry sectors because they rotate in importance to the economy. E.g. Technology was hot in 1999 and Commodities were hot in the 2006.
- You diversify debt holdings with different terms to maturity when you have no clear idea of the future changes in interest rates.
- You diversify between companies because they compete. Some will be winners: others losers. Read this disheartening summary and argument concluding you need a LOT more than 15 stocks in a portfolio to reduce risk. Then read this more optimistic summary.
The number of common stocks you should own also depends on their riskiness vs. your personal tolerance for price volatility. Diversification will only reduce the volatility of your portfolio's returns down to the level of the total market's own volatility, but your choice of risky assets may predispose you to additional price swings. Eg. If your experience with your own portfolio of small or mid-cap stocks is that commonly 3 at any time have tanked 33%, but you can only tolerate a 5% drop in the portfolio's value (in addition to any over-all market drop), how many stocks should you own?
| # of stocks that fall at once ||3 |
| times magnitude of drop ||* 33 % |
| equals sum of magnitudes ||100 |
| times tolerable portfolio drop ||* 5 % |
|equals # of stocks in portfolio ||20 |
|Check this does not change your assumption on the first line.|
People living and working in one-industry towns should consider NOT owning real estate in order to allocate risk away from the same economic exposure of their job. For the same reason, holding stock in the company you work for increases your risk. Asset allocation won't accomplish much if all your assets are based on the fortunes of one company.
Most all investors are sorely tempted to 'time the market', i.e. to rotate their ownership of asset classes through the business cycle. We all think we can avoid losses by (e.g.) selling equity and buying bonds at the peak of the cycle. The research is not clear whether most people can do it. Sometimes we do not recognize the inflection point. Other times the economy is not working like a theoretical business cycle. E.g. the 2000 tech bubble was not a business cycle event - there was no constraint from limited capacity at its peak. E.g the 2008 liquidity crunch was not a business cycle event, although it caused a business recession. A lot of theory says we should just set the asset allocation and hold. But the urge to meddle is very strong.
There are problems with asset allocation and diversification.
- Costs can increase. Some asset classes have transaction costs much higher than for simple company stocks, for example real estate. Some require much more intensive management, for example private equity. See Sheet 15 of this spreadsheet for the effects of rebalancing transaction costs for debt.
- The size of some asset classes is small. When large numbers of investors pile in/out, their decisions cause prices to whipsaw. Liquidity is necessary for efficient trading. However, the long-term buy-and-hold investor will be impacted less.
- The different classes may be driven by the same economic factors. For example all risky assets will increase in value when interest rates are low and the economy is growing. A well-known adage is "In a crisis everything correlates". During the Credit Crunch of 2008, the equity markets in all developed countries have been perfectly correlated. The graph below is quite different from the divergent, uncorrelated historical returns.
INTEREST RATE RISK
Changes to market interest rates impact the value of most investments. Think of interest rates as a proxy for the discount rate you use to value investments. When you demand a greater return, you pay less for the security, and vice versa. So too when interest rates go up, the value of most investments goes down.
One bond metric is its "duration". This measures its price-sensitivity to changes in interest rates. Duration is calculated by weighting the cash flows from a debt security by their timing. (See examples of calculations). It's interpretation is roughly: "duration equals the expected percent change in value of the security that will result from a 1% change in the market interest rates". E.g. A bond with duration = 4 may be expected to increase in value 4% if market interest rates drop 1%. Here is a quick calculator.
Duration reflects how far out into the future the cash flows are. A change in interest rates has a larger impact on cash flows farther into the future because the effect gets compounded for each year. When comparing two securities with the same maturity, the one with the smaller distribution (e.g. a strip bond) will have a larger duration than the high-yield bond. When comparing two securities with the same current yield, the one with the longer maturity (e.g. a perpetual preferred share) will have a larger duration than one with a short maturity.
The return you demand for any security is grounded in the other investment opportunities you have. You always have a choice. This concept is called your 'opportunity cost'. All returns are grounded in the interest rate you 'could have got' from a safe government debt. On top of that rate you add your required return for specific risks of the security. Regardless what returns are added on top, if the rate on government debt changes, so too will the rate for other securities.
Very short-term treasury rates change because a central bank decides so, but longer term rates change because market participants bid up/down the value of debt. Normally a change in short rates gets reflected in the longer rates - in the same direction. An increase in the short rate will make all longer rates less attractive because their existing premium no longer compensates for term risk - so the long debt's rate will rise as well. But this relationship can be reversed. A Government actively increasing short rates in order to slow down the economy can be interpreted as insurance they will not allow inflation to grow. The lower inflation expectation can lower long-term rates.
Do not conclude that because long bonds have a higher duration that they will experience much larger changes in value when Central Bank Rates rise or fall. Remember the definition of duration - "the change in value resulting from a 1% change in the interest rate". The second factor to consider is the 'interest rate' that is changing. A change in the Bank Rate will not result in an equal change in the yield of longer-term bonds. Since Central Banks have control only over the very short term rates, it is these that show the greatest volatility. When the yield of a 3-month Tbill may rise 3 percent, the long bonds may rise only 1 percent.
The reduced volatility in yields for long-term bonds lessens the effects of their higher duration. You have to compare a long bond with duration (say) = 8 changing its rate by 1% versus a 5 year bond with duration = 3 changing its rate by 2%. The value of the long bond would be expected to change 8% while the 5 year bond would change 6%. You need a spreadsheet to predict the effecthow bond prices change of rate changes on the price of a bond. Since this website is not really about bonds, there is a separate page discussing how bond prices change as they ride down the yield curve, and what losses would be expected from a change in market rates, and how to use the spreadsheet (Excel and OpenOffice).
The 'change in interest rates' that gets used with duration to predict pricing changes is also different for corporate debt (versus Treasuries). Corporate debt yields include a corporate risk premium over treasury yields. Often when Bank Rates are rising it is because the economy is booming. This reduces corporate risk and lowers the risk premium - leading to less impact on security pricing.
A product that hedges interest rate risk is the floating-rate debentures. These pay interest at rates that vary with the Prime Rate. As long as the coupon reflects current market yields, the security will not lose value due to interest rate risk. These will not hedge inflation though. Governments can keep short rates artificially low (and below inflation) when the economy is weak in spite of the inflation.
It is not just debt that loses value when interest rates rise. The equity of utility companies will also lose value. Their high dividends are a proxy for interest payments. The companies' profit and prices are fixed for extended periods by regulators. Owning common stock of active businesses is your best hedge. You want companies with the pricing power to adjust to changing interest rates. Ask whether they can increase their prices to cover their increased financing costs.
Relationship between Interest Rates and Inflation
Often there is a direct correlation between changes in interest rates and inflation. The theory of a business cycle says that as an economy heats up:
- Production increases and greater demand for parts and supplies drives up these prices.
- The increased input costs get passed to consumers with higher resale prices = consumer inflation.
- Companies use all their existing capacity until more capacity is needed. To finance the construction of that new capacity businesses borrow. The increased competition for borrowing drives up the interest rate businesses are willing to pay.
- At the same time, the central banks do not want big booms and busts so they try to damp economic swings. They raise short-term rates with the objective of making that new capacity more expensive and less likely to be built.
But that theory of a business cycle does not always happen as advertised. For example, the double-digit inflation of the 1970's was caused by banks keeping interest rates low in an attempt to stimulate a weak economy, at a time when imported inflation from the oil shock was high (leading to stagflation). Then, in the 1980's interest rates stayed high even while inflation fell because of investors lingering fear of inflation.
So hedging investments for interest rate risk will not always hedge away the inflation risk. One way to hedge both risks is to buy only short-term debt. That way you continually roll over to new debt issued at new interest rates that reflect current thinking about inflation. The trade-off though, is the lower return you earn on these products.
Savings are 'deferred gratification'. The only reason you don't spend your money now, is because you expect to have a greater purchasing power later. So savers always demand that investments provide a return that will cover, AT THE LEAST, the loss of purchasing power caused by inflation. Interest rates on debt will be higher when high inflation is expected. P/E multiples on stocks will be lower when higher inflation is expected.
Be clear in your mind the difference between claiming an asset class is a hedge against inflation because: "The returns of this asset class exceed inflation" and the claim that an asset class is a hedge because: "The returns of this asset class are correlated with inflation". It is only the latter that is correct. For example T-bills are an excellent hedge against inflation because their returns are strongly correlated. But T-bills have low returns and in some time periods return less than inflation. Hedging is all about the co-movement of returns.
It is common to hear the statement "Equity returns correlate with inflation" or "Stocks hedge inflation". This is false. Inflation has explained only 2% of US equity returns, and only 3% of Canadian equity returns.
Since the 1970's were the only period of hyper inflation in North America it is helpful to look there to see how stocks reacted. But by 2010 the world has changed in two ways.
a) Stock owners are now spread worldwide and their personal inflation may be quite different from the inflation faced by the operating company. E.g. an Indian facing the high inflation of a growing economy, may hold the stock of a US REIT when US inflation is near zero.
b) Large companies today sell and operate all over the world. Their results include the variety of inflations faced by those divergent economies. It should not be assumed that if a stock is listed in (e.g.) the US that its operations are impacted by US inflation.
The misunderstanding that equity returns hedge inflation has come from academic's love of measuring everything in 'real' terms (after inflation is removed). The following chart shows an arbitrary sequence of yearly inflation percentages in the first column. The second column lists an arbitrary rate of return. It does not matter what value is used. The correlation between the two attributes is essentially 0 %. Changes in inflation cannot 'explain' the changes in returns because there are no changes in returns. Now consider the 'real' rate of return in the right-hand column. It is the return LESS the inflation. The correlation between the real return and inflation is essentially 100%. Why? Because now inflation is built into the return by its very calculation.
|Inflation ||Returns||Real |
|4.5 ||10.0 ||5.5 |
|3.4 ||10.0 ||6.6 |
|2.9 ||10.0 ||7.1 |
|5.0 ||10.0 ||5.0 |
|7.5 ||10.0 ||2.5 |
|10.8 ||10.0 ||-0.8 |
|10.7 ||10.0 ||-0.7 |
|7.5 ||10.0 ||2.5 |
|8.0 ||10.0 ||2.0 |
|R squared ||3% ||100% |
You should make it a rule to immediately distrust any argument that uses real-returns (with inflation removed). There is just no reason to make the adjustment, and many reasons NOT to. Inevitably the purpose of the exercise is to fudge results to get the conclusion desired.
E.g. the investment industry promotes the ownership of stocks when inflation threatens with the claim of correlation (argued above).
E.g. the promoters of high (or growing) dividend stocks reduce historical capital gains by inflation, leaving dividend yields intact, to bolster the importance of dividends (see Preferred Return - NOT (v)).
E.g. foreign country inflation is removed from foreign stock index returns in order to be able to claim that currency exchange rates supposedly have no impact on returns (see Hedge Foreign Currency).
It is common to hear the statement "bonds lose value from inflation because their principal is fixed". But in fact the owner is compensated yearly for inflation by the interest rate he demanded at purchase. Expected inflation is not a risk. The risk lies in the actual inflation turning out to be different from that expected at the start. Your expectations may not pan out. Buyers of US T-Bonds in 1962 realized 5-yr, 10-yr, and 20-yr returns that were lower than inflation - negative real returns. Buyers would never have agreed to those rates if they had only known at the start.
Debt with longer terms have more inflation risk, because the inflation 5 years from now is harder to predict than tomorrow's. Plus, any error in the expectation will be compounded over a longer time - exacerbating the error. So 30-year bonds have more inflation risk than 30-day T-bills. (This is included in the concept of 'term risk').
OTHER HEDGE POSSIBILITIES
An excellent textbook chapter on the inflation protection provided by real assets is available in this readable pdf by Ang
- One way to hedge against unexpected inflation is to buy Government debt whose value is adjusted each month by the Consumer Price Index of inflation. In the US these are called TIPS. In Canada they are called Real Return Bonds. The best source for a factual understanding is bylo's webpage.There are three problems.
- You must accept that the government's measure of inflation is correct. There are many people that do not agree with their methodology. If you think the CPI understates inflation, then your returns will also underperform.
- The second problem is caused by the market's valuation of the product. The only people buying this product are explicitly afraid of inflation. Their estimate of future inflation will be higher than estimates by people buying regular bonds. Technically, the difference between the regular bond's yield and the inflation bond's coupon equals the inflation expectation plus the value of getting rid of the inflation risk. But this difference in perception means RRBonds may be overpriced compared to regular bond.
- There are tax issues to consider. Each month the principal is revalued by the rate of inflation. This increase will not be recovered until you sell the bond, yet it is taxable today. That results in a cash-flow mismatch. Try to hold these bonds within tax-protected accounts.
Many investors' understanding of these bonds starts from the wrong premise that inflation rates are the same as interest rates - that a change in one results in the same change in the other. If you are still unclear on this please re-read the two sections above. Real return bonds do NOT provide any protection from changing interest rates resulting from changes in the supply/demand balance or the market's changing valuation of risk. These factors can result in changes in RRbond valuations far greater than any loss from unexpected inflation.
The graphs below come from an Excel spreadsheet (or OpenOffice) kept roughly up-to-date. The top graph shows that the inflation factored into RRbond prices is long-term inflation expected over the life of the bond, not the volatile annual CPI heard in the media. The Blue line shows that for a long time after the 1970's inflation had ended, the market still worried about unexpected inflation. Investors in the 1990s gave away 4% to get inflation insurance. They recovered from the bonds only about 2% subsequent actual inflation (the orange line). They grossly overpaid.
Since then the market has developed a trust in Central Banks' ability to control inflation. The inflation expectation built into RRbonds has rarely varied from the 2% to 3% range - even in 2011 with the US printing money and exporting inflation.
The second graph shows that RRbond yields fell during The Great Moderation right along with the yields of normal bonds - from factors that had nothing to do with inflation expectations (that were static). Because the RRbond's coupon is so small its duration is larger - and the fall in yields resulted in greater capital gains for RRbonds vs. normal bonds. It is this volatility of real yields that made RRbonds a weak hedge against inflation. Correlations between TIP's returns and inflation between 1997 and 2011 was just 10%. Instead, TIPSs were highly correlated (64%) with other Treasury bonds - posting higher returns and more volatility than Treasuries.
In 2010 retail investors flocked to these bonds in the belief that inflation and rising interest rates was immanent. They are predicting a world where the parallel lines of the second graph diverge. They think Long-bond yields (green line) will rise only because of increasing inflation (blue line), so that the yield of RRbonds (burgundy line) will stay steady. Is that a reasonable assumption? When actual inflation spiked up to 4% in the recent past, long-run inflation expectations did not follow, and yields continued to fall.
If yields of BOTH types of bonds rise, even if at different rates, the change in RRbond yields will generate a large capital loss because of their larger duration. If RRbond yields rise 0.5% with duration = 15 then you expect a capital loss of 7.5% - all at once at the time the rates change. RRbond owners would assume this loss in order to protect themselves from a loss from unexpected inflation of 1% or 2% realized each year.
The decision to buy a RRbond is three steps. First you decide whether you want to own debt (generic). In that decision you incorporate your expectations of changing supply/demand, valuation of risk and interest rates. Once you decide you want to buy debt, then you decide whether RRbonds are the better product compared to a normal bond of the same duration. This is decided by comparing the inflation expectations built into the current price (the difference in yields = blue line at time of purchase), to your own expectations of inflation. This is your cost / benefit trade-off.
Finally you must decide whether to buy specific actual bonds that mature exactly when you will need the cash, or to buy a RRbond ETF and to give it a strategic asset allocation percentage. Specific bonds held to maturity can immunize cash flow needs from inflation, but the other strategies have little value.
- Another way to hedge inflation (if you can stay the course long enough) is to buy equity shares of businesses that can pass their rising costs along to their customers (probably not utilities). While it is true that equity returns in the short term do not increase with inflation, over longer periods companies catch up with their pricing. See what happened in the 1970's on Sheet 30 of the Data Spreadsheet - how the spread between earnings and stock prices diverged and then went back on track. The market re-prices stocks lower when interest rates rise from inflation fears, even though earnings' growth keeps up with inflation. See how the Earnings Yield spiked in the early 1970's on Sheet 3 of the same Data Spreadsheet. But the stocks' earning yield will go back down when the inflation scare subsides. The same cannot be said for debt. Unexpected inflation will cause reductions in 'real' returns from which there is no subsequent recovery. Debt returns have no reversion to the mean.
Even if stock price multiples fall with higher inflation, dividends may keep up. If companies' pricing and profits increase at least as fast as inflation, and assuming the same portion of profits are paid as dividends, then the $$dividends should rise with inflaion. That has been the average historical experience worldwide. But Dimson et al.(page 19 Table 4) found some wide divergencies between countries.
|Annual Real Dividend Growth 1900 - 2011 (%pa)|
|Australia ||1.10 ||Netherlands ||-0.51 |
|Belgium ||-1.48 ||New Zealand ||1.26 |
|Canada ||0.84 ||Norway ||-0.13 |
|Denmark ||-1.13 ||South Africa ||0.95 |
|Finland ||0.49 ||Spain ||-0.6 |
|France ||-0.90 ||Sweden ||1.77 |
|Germany ||-1.16 ||Switzerland ||0.46 |
|Ireland ||-0.94 ||United Kingdom ||0.46 |
|Italy ||-1.52 ||United States ||1.37 |
|Japan ||-2.39 ||Average ||0.11 |
But you should not forget the two differences between today and the 1970's listed above. Inflation is personal to the investor, not the company, and inflation faced by the company may have nothing to do with the inflation of the country of its stock listing.
- It is said that buying gold and commodities is a hedge for inflation. But over long periods their returns are lower than even inflation. These products do not 'grow' because they have no profits to reinvest. They have a market value that rises and falls, but no consistent up-trend.
Products whose payouts are prearranged to increase from year to year do NOT hedge inflation. These include annuities and GIC's. Remember that 'risk' is in the unknown future differing from the expected. Any increase that is pre-set will not, by definition, reflect the actual inflation.
Real Estate is often presented as an inflation hedge. But prices do NOT necessarily keep up with rapid inflation. See the discussion and graphs on the Real Estate page. The rents from RE may well be an excellent inflation hedge though. In the short-term it is your operating returns that count, not the eventual capital gain.
Some people claim that a home-country's inflation can be hedged by investing internationally. For a detailed discussion read the argument on the Hedge Foreign Currency page.
Although not a hedge, high-yield corporate debt will be impacted less from inflation changes than will low-risk government debt. This is because more of their yield is on account of their risk premium, on top of inflation. Any change in the inflation portion will be a smaller change relative to the total yield, because the total yield is bigger. Also, inflation usually appears when the economy is smoking hot - just when business is booming - when investors have no worries and demand a smaller risk premium.
The liquidity of an investment refers to:
Real estate is very illiquid. It takes months to close the deal; and lawyers, agents, appraisers, taxes and movers can cost almost 10%. In contrast, purchasing a stock takes seconds, cost about $5 and has millions of players making the market.
- how fast it can be bought/sold
- how high the transaction costs are
- the balance and quantity of buyers and sellers in the market so that big volumes won't 'move the market'.
The importance of this risk depends on the individual investor. E.g. pension funds have stock positions worth millions of dollars. They have a hard time buying/selling a position because of this size. There are not enough buyers on the other side of the transaction. In contrast, small retail investors can invest in penny stock with very low volumes. Because their holding are so small they will not move prices.
The importance of transaction costs is related to the frequency of trading. Real estate is usually held 5-7 years, so the higher commissions are more palatable. In contrast, stock brokerages that earn revenue from trading fees, drop their per-trade commissions because that encourages a much higher frequency of trades.
Investors require higher returns when they commit their money for a longer period of time. We can only guess the future. The farther into that future the harder to predict. A company that is perfectly healthy today, may go bust in five years. Inflation ten years from now is harder to predict than tomorrow's. Your own needs for cash become harder to predict over longer periods. Maybe you will be dead before that bond matures.
Bond holders measure this risk two ways.
- A yield curve refers to a chart that plots the market returns required for debt of different maturities. A 'normal' curve will rise as the term gets longer. Interest rates for long-bonds are higher than for T-bills. See also this more detailed account from the Globe And Mail. A dynamic chart of the US yield curve as it changes over time is available at StockCharts.
- "Payback period" measures the number of years before all the cash flows from the debt exceed the original investment - when you have recovered your cost, but earned no return. The longer the payback period, the more risky. E.g. a mortgage is less risky to own than a bond. The bond pays only interest until maturity, but the mortgage's payments include a portion of the principal as well. This metric also shows up in the stock analysts' "Debt to EBITDA" ratio. EBITDA is a proxy for the cash available to pay back the debt. The ratio equals a theoretical payback period.
Preferred shares are issued with different attributes. Some have a specific redemption date and are more similar to bonds. Perpetual preferreds never mature and so are much riskier. Common stocks have no redemption rights so they are most risky.
This risk applies to both the reinvestment of principal at the end of the investment and also the reinvestment of the income paid out along the way. The problem is that the rate of return to be earned on the next investment is unknown at the start of the first investment.
Consider having to choose between (A) a 2-year investment earning 10%, and (B) a 1-year investment earning 12%. While it is clear that (B) is the better choice if only the first year is considered, it is unclear what opportunities will be available in a year's time for reinvestment. If you cannot find anything offering at least 8%, at that point, then (A) would have been the better choice. The point is that you don't know ... you face reinvestment risk.
You must trade off "Reinvestment Risk" against "Term Risk" (as discussed above, the investment that returns your money faster is less risky than one paying out only at the end of the term). Term risk refers to the risk of default; the risk that the solvency of the borrower will have deteriorated; the risk that market conditions will have changed. In truth, recovering cash early is really a double edged sword. Those payments during the term of an investment must be put to work on their own account. At the start there is no way to know what rate of return they will earn. An example of this is the escalating rate GIC. The surety of automatic reinvested interest is preferable from this point of view.
This same risk is called "Pre-payment Risk" in the context of mortgage-backed securities. Some mortgage products allow borrowers to pay off their debt early. Borrowers will do that when market interest rates fall and they can get replacement mortgages at lower rates. That leaves the investor who loaned them the money with cash to reinvest at those same low rates. While he might have expected to earn 8% for 10 years, all of a sudden the investment ends after 2 years, and his only options are to reinvest at 5%.
The math for calculating the Internal Rate of Return (IRR) or Compound Annual Growth Rate (CAGR) presumes that the reinvestment rate is the same as the original investment's rate of return. But in many cases that presumption is wrong. People with finance education will understand that this problem (the presumptions in the math) can be overcome by analyzing investments using Net Present Value (NPV). But this is too difficult for beginners to learn.
FOREIGN CURRENCY (FX) RISK
In order to reduce economic risk you are told to diversify investments internationally. But that process exposes you to changes in the exchange rates of foreign currencies. A foreign investment is worth less to you after its currency weakens, and vice versa. Does the FX exposure have a net benefit or does it increase risks? Most all papers generated by the industry tell you that FX exposure reduces your risks - that you should not hedge. But their position is full of holes and most probably self-serving. Most all their products had NO hedging prior to 2005. Only after investors had huge losses did they provide hedged products. See the detailed discussion at Hedge FX. But before you switch to that page make sure you read the discussion above in the Inflation section, on the correlation between inflation and equity returns.
One of the reasons investors tend to invest most of their money at home (home country bias) is because they feel comfortable with their knowledge of the political climate. Generally speaking investments are safer in democratic/capitalistic societies. But all governments can
- confiscate property
- impose tariffs and taxes
- regulate costly environmental compliance
- go to war and blockade access
- even bail out investors (from a loss) when enough political pressure is applied.
But business now is international. Business leaders must play the political game and make risk/return assessments. The only thing you can do is either demand higher returns for investments in riskier countries, or stay away completely. Standard and Poors provides ratings of sovereign countries you can use, also the Economist Intelligence Unit. The Belgian Export Credit Agency also publishes ratings.
FINANCIAL VS. OPERATING RISK
Financial risk refers to leverage. The way you chose to finance your portfolio or your business imposes different fixed and variable costs. The higher the fixed costs (interest expense) the higher the financial risk. See also Math for Leverage. Operating risk refers to the business' operating costs in relation to its revenues. A business with low profit margins (operating profit as percent of revenues) is more risky than one with high margins.
Retired people living off their principal as well as income, risk running out of money before they die. This may be because
- investment returns were less than expected,
- they made such a poor investment that they lost the principal (on top of the income),
- their investment returns were more variable than expected so that yearly withdrawals had a bigger negative effect,
- inflation was higher than expected (and returns did not compensate),
- they lived longer than expected (longevity risk), or
- they spent more money (in real dollars) than expected.
There are three ways to offset these risks.
- Members of a Defined Benefit Pension Plan (DBPP) that is indexed to inflation are hugely lucky. Not only is the investing risk and work assumed by others, but members benefit from the deaths of their cohort (splitting the pot between fewer beneficiaries). And the best part - longevity risk is completely taken care of.
- People without a DBPP can purchase annuities (NOT variable annuities) from insurance companies. These pay out a specified amount until death. The payments can be stable, or increasing by a specified rate, or indexed to inflation. They can start immediately or at a later date.
- Owning your home provides longevity insurance. Land never goes away. It provides accommodation until the house falls down.
Most business sales are not paid for at the time. The seller 'invests' in his client by accepting debt. The seller faces
One solution is to sell the investment. Businesses known as 'Accounts Receivable Factors' will buy baskets of receivable and collect the money themselves. Of course the amount they are willing to pay for the basket is discounted for their anticipated costs and additional profit.
- the risk of never being paid (repayment risk)
- not knowing when he will be paid (term risk) and
- not knowing how much it will cost him to collect (liquidity risk).