Investment Risks Explained “Never stop taking risks. Just keep reaching.”- Ryan Eggold
By Christian Armbruester
Investment risks. For most people, taking risk is something very negative. After all, the very definition of “risk” is that something can go wrong. But without risk, there cannot be a return. That is a function of the “free lunch” theory, and it merely means that you cannot get something for nothing in financial terms. Only when we put our money at risk can we expect to get rewarded, otherwise there would be no incentive for anyone to do anything at all. As such, we should also embrace the very notion that to make more; there is a chance that we have less.
In today’s world of finance, there are hundreds of different strategies, thousands of products and millions of service providers to choose from. Coming up with a coherent plan has never been more complex, which is ironic because wasn’t the whole point of fragmenting the investment universe to make it more efficient and more comfortable for people to deploy capital? The other problem is the endless jargon and all the different names for the various strategies. We have equities, beta, long-only, or even systematic and they could all potentially mean the same thing, yet the underlying risk could still be a complete mystery. The tools we have at our disposal to make sense of all of this range from portfolio management theory (mainly Markovitz), to strategic asset allocation and value-at-risk (VAR) models to keep it all in line.
The goal is to add value in some form or another, but the problematic part is that we are living in a random world and no matter how smart we may think we are, predicting the future we cannot. This makes a mockery of all the fundamental analysis, macroeconomic viewpoints, and technical trading models. The fact remains, none of the tools we have at our disposal will help us make better forecasts about what will happen tomorrow. Therefore, the only thing one can do is to focus instead on diversifying the risks. Very much as in not putting all your eggs in one basket. The issue is, of course, how do we measure and classify the different risks, mainly because the names, descriptions or asset class definitions are not of much help? As we saw in 2008, everything from corporate bonds, to equities, commodities or real estate funds went the same way, without much protection from so-called diversification, at all.
So, what to do? The answer is remarkably simple when broken down into the necessary components: you either own something, or you are lending to someone (who probably owns something). If you own something, generally you need prices to go up from where you bought them. Whereas if you are lending money, your risk is that someone doesn’t pay you back. In other words, there is either price or credit risk. Credit Risk Price Risk
The most efficient way to get exposure to price risk is equities, and for credit risk, it is bonds. Together, they account for more than $300 trillion in total market capitalization and issued debt. If you do nothing else and merely focus on these two things (as most investors do), you will have done very well in the last few decades, as both forms of risk were handsomely rewarded.
But doing only two things also has its drawbacks. For one, if they can both perform well together at the same time, then they can also underperform at the same time. Two, the reward for taking on the risks can vary dramatically, and one only has to look at those people that bought the stock market in July 2008, versus those that bought in March 2009 (note: there is a 60% difference in price). This is called market (or beta) risk and can be found in equities (both private and public), but also in broad holdings of real estate and commodities.
Therefore, it would be well advised to diversify risk even further, and here we have some real choices thanks to the very proliferation of financial products that we deemed earlier to be the cause of our concern. Primarily, given that the most considerable risk is that prices go down, why not invest in something that would benefit if they do go lower? This is called “shorting” in financial jargon, and it merely means that you can sell things as quickly as you can buy things in today’s complex world of finance. If you buy (long) and sell (short) something at the same time, you have the risk that they go in the opposite direction, or the relative price movement.
Why take on relative price risk? Foremost, because it eliminates market risk. The beauty of owning BMW and being short Daimler at the same time, for example, is that if the market goes down 50%, you will probably have lost half of your money in one, but you will also likely have made 50% in the other. Then there is also something called “alpha,” which is the reward for taking on this risk. Essentially, you are betting on one price outperforming the other; this can be due to statistical reasons, structural issues, or a fundamental view. The critical thing to note is that it is an entirely different risk than owning assets outright and worrying about the prices going down.
But there is more, and we can also take on the risk of a specific price movement, or so-called “gamma risk.” The Brexit, for instance, was something that was entirely dependent on a vote on a particular day. Through various instruments or wagers, one could take a view on either outcome, with that picking Brexit having made very handsome rewards for getting it right. You can bet on corporate mergers, elections, economic results, company earnings or even start-up ventures. The critical thing to bear in mind is that betting on an outcome that may or may not occur means you either make a lot of money if you are right or no money at all if you get it wrong, mainly through the use of leverage, options, and other derivatives. Taking on specific price risk is indeed a very high risk, but it is also very different to credit, absolute or relative price risk.
When lending, you can also incur very different risks depending on who you lend to and for how long. Generally speaking, the longer you lend and the less secure, the higher the risk. Though, the risk of lending to governments is very different from lending to corporations. Mostly this is because countries can print money, but also given the “lender of last resort” status of central banks that aim to secure the soundness of our financial system and guaranteeing the debt the government issues. We can also lend on the basis of a specific project, house or situation. The risk of such is called “structured debt” and is neither a government or a corporation defaulting, but rather the security of the particular risk you are lending against.
Putting it all together, we now have six entirely different risk categories that we can use to diversify our asset allocation:
As long as you invest in any combination of all of these risks, you can genuinely be diversified and manage your investment positioning very precisely. There is no need to make predictions or try to time the markets. The trick is to keep things very clear and try not to blur the risks. No more so than in the world of investment, is it critical to make sure you get exactly what you pay for. If you want relative price risk, you don’t want someone giving you absolute price risk at a higher cost. The total costs to implement your investment strategy is known as the Total Cost of Exposure (TCE), and it includes everything from commissions, to management & performance fees, taxes, administration and monitoring expenses that are incurred when investing. The TCE significantly affects where you are on the risk curve and highlights any unwanted or, worse, unrewarded risk.
The concept of taking different forms of credit and price risk should be clear to anyone, and the benefits from true diversification (risk versus asset class allocation) are available to everyone. All it takes is a different focus, away from trying to predict the unpredictable, and instead on the costs and effectiveness of implementing your investment strategy.
Christian Armbruester has more than 25 years of experience in investment & business management. His family’s roots are in manufacturing and metal trading. From 1996 to 2003, he managed proprietary trading books for derivatives and arbitrage strategies at Bankers Trust and Credit Suisse. Since then, he has acted as Chief Investment Officer for hedge funds, asset managers and Blu Family Office. Christian is one of the founders of Blu and manages investment strategy. Christian holds a BSc in Finance & Economics from Miami University (1992) and an MBA from Columbia Business School (1996)