A LESSON LEARNED ABOUT RISK PERHAPS NOT FULLY LEARNED

I thought we all could use a break from taxes and this issue returns to economic matters discussed in earlier issues dealing with the sub-prime crisis.

The sub-prime crisis and Great Recession caused most to step back from risk taking and chasing returns, and to seek safer harbors for investments. For a time people were repeating the old adage “it is better to obtain a return of your principal than a return on your principal.” Yet, as the U.S. economy slowly seemed to be improving, investors became impatient with historically low returns on safe investments cause by the Federal Reserve’s continuing non-restrictive monetary policy. Investors once again began to think that the extra return afforded in less safe investments is obtained for free. They began again underestimating the added risk from chasing higher returns. Greater risk taking came back in vogue and was evident in investor behavior:

• Pushing up the stock market on profits generated by most companies through cost cutting, not revenue growth

• Fleeing the low interest US environment to higher returns and risk in emerging and developing markets.

• Pouring money into highly volatile alternative investments such as commodities.

• Finding allure in the higher returns promised in junk bonds.

The commodity market swoon last week has shaken confidence and investors are again seeking respite from volatility but a review of the nature of risk seems appropriate.

RISK IS A NORMAL ASPECT OF LIFE

Things will go wrong and that is risk. Just yesterday I was about to leave my home to visit my mom on mother’s day. I pushed the button to activate my garage door opener and nothing happened because the spring on the door had snapped. Garage door springs don’t snap often for any one homeowner, but across the nation many snap every day and every time I leave home that risk presents although I do not consciously think about it every day. If the risk were not tolerable, I could learn how to make the repair and have the tools and parts on hand. But, I can live with that risk even should it occur at an inopportune moment. Many have offered wisdom on risk taking:

Robert Frost: “We took risks. We knew we took them. Things have come out against us. We have no cause for complaint.”

Harold Macmillan: “To be alive at all involves some risk?”

We consciously and unconsciously take risks every day. We drive to work not thinking all the time of the likely risk of an accident and remote risk of death. We put the risk aside because driving is a must if we are to get about. We board planes for business trips and vacations assuming the risk flight because we view the hazard as remote and always happening to someone else. Some of these daily risks are born from absolute necessity and some are voluntarily assumed. Hurricane Andrew, the Japan nuclear accident and Wall Street’s meltdown are all examples of outliers. Events at the two ends of the bell curve we foresee in the back of our conscious minds but often ignore to our peril. For, outliers do occur regularly and we should understand that for each of us there are some remote risks, however unlikely, we cannot afford to assume. Most who are sane would not play Russian roulette with a gun having 1,000 chambers. The risk of a bullet in the discharged chamber is remote but the result is simply too drastic.

Risk is also an element of every investment alternative. Investment risk is directly related to reward. Before the sub-prime crisis many chased performance seeking the highest available rate of return thinking that the return in excess of other available rates was a gift. Many were unaware that they were taking on much greater risk than for lesser returning investments.

Many did not know of or follow the advice given by General George S. Patton who had said, “Take calculated risks. That is quite different from being rash.”

I was speaking with a stock broker before the current market upswing. He said “there isn’t much risk left in the market because it has already fallen so low.” I asked him if he’d considered specific company risk. The risk that a company you hold may go out of business may not be reflected in the averages. Equity value can disappear very quickly, e.g., Wachovia.

I visualize investment risk by thinking of a ladder braced at the bottom and pointing straight up in the air. The ground is the so called “risk free” U.S. Treasury rate for a short term, mid-term or long term obligation. Initially, each percentage point above the risk free rate takes you one rung up on the ladder. The higher on the ladder you climb the harder and faster will be the fall. The presence of additional risk factors might take you two or three rungs up the ladder for each percentage point return increase.

Investments with any of these elements add some measure of risk:

1. Foreign situs (stocks trading on foreign exchanges); Foreign law, culture, markets and trends are more difficult to assess for U.S. investors. Thus, diversification and higher stated returns may be offset by other hidden or unforeseen outlier risks such as political instability;

2. Innovative or new investment products lacking a track record such as “managed futures” which often make more money for the creators than for investors;

3. Several steps removed from the original transaction (securitized mortgages);

4. Complex and not fully understood (derivatives like credit default obligations);

5. Gives control of your funds to an individual (e.g., Bernard Madoff) without adequate checks and balances as are present within large financial institutions;

6. Hard to value (securitized mortgages); and,

7. Volatility: The recent plunge in silver and other commodity prices indicates how market upswings pegged to expectation and not supply shortages can turn around quickly and unexpectedly.

8. Includes assumptions: In Noel Behn’s 1966 espionage novel “The Kremlin Letter (made into a terrific John Houston 1969 file featuring to name some Orson Wells, Max Von Snydow, Patricia Neal, Bib Anderson and George Sanders), a spy teacher makes students who are bad write 500 times the sentence, “Live longer – minimize assumptions.” The same can be said for investments. “Avoid loses – don’t buy assumptions. What can go wrong will go wrong.”

RISK DEMANDS ATTENTION

Some other points to keep in mind:

1. Think of the return not as a “rate of return” but as a “rate of attraction.” That is, the rate an issuer must pay to obtain capital from investors having alternative choices. When, for example, the U.S. Treasury offers mid-term notes at 3% and you are offered 15% on a private mid-term investment opportunity, the rate is 15% because investment risk is such that investors will not buy at less than that offered rate. The rate of attraction is a measure of risk.

2. Advisors often question investors about their “risk tolerance.” This is a psychological measure of the degree of risk you can tolerate without losing sleep. They less often consider “risk capacity” or the amount of loss you can handle given your present financial situation, age and health. A 25 year old may be able to make up over time the total loss in a risky investment, a retired 70 year old cannot. Donald Trump can assume risks that an investor having a $300,000 portfolio should not. Simply put:

An egg should have enough common sense to know its limitations. An egg should not sit on a wall; for, should an egg fall; well, we all know what happened to Humpty Dumpty.

3. Be wary of the geek’s risk models. Wall Street, before the sub-prime mess exploded, lived in a euphoric world of high returns and perceptibly low risk but the low risk evaluation was premised on faulty models. The computer risk models employed considered the most likely risks (those falling in the 99th percentile of the bell curve) but failed to warn of remote catastrophic risks not part of the historical data on which the models were based (included only the prior two years which were bubble years). The programs did not consider that the unexpected (events falling at the ends of the Bell Curve normal distribution) occurs and not just once in a lifetime. Thus, the most dangerous risks are the one’s that computer models never predict because they fall outside of the data base. What we worry about rarely gets us; it’s the event we never see coming that is most devastating. Y2K was a dud but nobody foresaw 9/11.

TAK, SHTO DELAET?

A Russian, faced with an unsolvable problem, will often say, “

“Tak, shto delaet? (So, what’s to do?) My advice for what it is worth:

1. Don’t look at the stock market through rose colored glasses. Eventually companies must figure out how to grow revenues given the new financial paradigm of lower consumer spending, more stringent government scrutiny and continued uncertainty about the future structure of our tax system.

2. Most should be cautious about large bets on alternative investments unless volatility is fully appreciated and one is willing, can afford to and needs to assume the added risk. Gold is scarcer than paper money and must be mined not printed; but, like paper money, gold has little inherent value other than as an ornamental. Gold, unlike diamonds, is not easily transported across borders if things fall apart. Its value is created by the perception that others will want to own gold if paper money devalues. Gold is an impractical medium of exchange given the size of today’s world economy. In a Japan like catastrophe, moreover, gold has little utility. Finally, inflation is one but not the only risk about; and, should the money system collapse, no one would accept paper and shares in gold funds, sold for dollars, would also become worthless;

3. Most should avoid the innovative new stars like managed futures. They were created to make money for the inventors and marketers.

4. Keep within your risk tolerance that you can sleep at night. But, even if you are a riverboat gambler, know your risk capacity and don’t bet more than you can afford to lose.

5. Most should be cautious about direct investment in foreign funds, stocks or bonds. The argument that they do not correlate well with the U.S. (and hence spread risk) has been largely disproved. Many large US listed companies and funds now have global exposure. The higher return in these remote developing or emerging countries is not offered for free. One is assuming more risk that the punch will turn toxic from many unknown ingredients that juice up returns.

6. Be proactive and question your money manager, broker or financial advisor. Don’t be lead to the wolf like a little lost lamb. It is your money, protect it.

7. Be skeptical of internet blogs. The internet has made every Tom, Dick Harry and Jane, a pseudo expert.

In Brooklyn the street wise know, “in this life you get nuttin’ for nuttin’ buster.”

This issue has been modified from an earlier version published as part of a series of monograms dealing with the Sub-Prime Mortgage Crisis and Great Recession (Steinberg Talks Tax, Vol. 3, No. 1, January 20, 2009).