Investing Is Stress-Free When You Learn This Trick to Eliminate Risk
In the last article, The 3 Questions to Ask Before Any Investment, you learned that returns, risk and liquidity were the three considerations for investment, in that order. This article double-clicks on risk and teaches how to eliminate that anxiety-inducing pest.
Let’s say you have two investment options: an outdoor ice cream parlor and an underground hot soup shop. When it’s sunny, which is most of the time, the ice cream parlor earns a fair amount of money, but the soup shop runs a loss, as its soup du jour goes largely uneaten. Conversely, when it rains, the ice cream melts away with the profits and there’s a line around the corner for hot soup.
You have enough saved to run one of these businesses for one period. Either one costs $7 and you have exactly $7. Given the projections above, how do you invest?
We’ll return to this example shortly, but do make sure you take a minute to answer the question for yourself. Your approach will provide some great insight for yourself on your current thought process.
The first thing you probably noticed is that both investments have outcomes where you actually lose money. That doesn’t sound like much of an investment! However, all investments and, indeed, any action in life involves risk, however minute. Crossing the street? There’s a very small chance that you get hit by a car. Buying a government bond? There’s a very small chance that the government defaults on the loan.
In general, people need to receive more money to take on more risk. If I had a pill that had a 50% risk of you waking up with a cold tomorrow, and I offered you $1 to take it, you would decline. If I offered you $10,000, you would probably take the deal.
Now if the pill had only a 0.01% of giving you a cold, you would probably take the deal for less money. That might be an easy $5. You take risks every day by leaving your home. Taking the bus during flu season has a higher likelihood than 0.01% of you catching a bug.
The relationship between risk and reward is what makes some asset classes offer higher returns. Treasury bills — loans issued by the US government that are payable within a year — offer low returns because there isn’t much risk on the US government defaulting in the next few months. A stock in a company in an emerging economy — a tech company in Brazil, for example — could offer massive returns, but could easily fall to zero. While the expected return is higher, it’s much less certain. The US government, on the other hand, tells you upfront how much it will pay you and has always delivered on its promises, at least for bonds.
Now that you understand the general relationship between risk and reward, let me wow you. Done well, there’s a concept that can get you the same return for a much lower risk! Or, conversely, you can take on the same amount of risk and have a better return.
Poof! Eliminate the Risk
You may have calculated the expected value of each investment by multiplying the outcomes by their probabilities and then summing them. The ice cream parlor receives $24 x 75% of the time minus $40 x 25% of the time. Both investments have the same expected value of $8. With a $7 investment, that’s a 14% return.
However, we said that this investment is for only one period. At the end of the year, if you invest in ice cream, you either make $24 or lose $40. If you invest in hot soup, you either make $56 or lose $8. You never actually make $8, even though it’s the expected value.
Warren Buffet, investor extraordinaire, famously said that there are only two rules in investing. “Rule №1: Never lose money. Rule №2: Never forget rule №1.”
That advice is so important because it’s much harder to make up for losses. If you invest $100 and lose 50%, you’re down to $50. You now have to make 100% just to get back to your original $100. You need a much better rate of return than your rate of loss just to break even. It’s easier to have a steady positive return over time than have to spend potentially years just to crawl back to where you started. Negative returns destroy your time and, remember, time is one of the three levers.
The question then becomes how to minimize your risk of loss.
Here’s where the magic happens. Instead of buying one asset, you find a partner and buy both assets together. Then you own 50% of ice cream and 50% of hot soup.
Whether it is sunny or rainy, one of your assets makes money and the other loses money, but together, you always make $8. You have the same expected return as either the ice cream or hot soup shops alone, but you have eliminated the risk. Heads, you win. Tails, you win.
Isn’t that amazing?
The reason this works is that the two assets are negatively correlated. That means that when one has a positive return, the other has a negative return. When one goes up, the other goes down. They both have a positive expected return, but produce that return from different situations.
Diversification is this strategy for increasing certainty in an uncertain world. You’ve probably heard the idiom, “Don’t put all your eggs in one basket.” You’ll end up with either all your eggs or none of your eggs. Good diversification isn’t just splitting the eggs between two baskets — it’s having different people carry the baskets.
Buying half of two ice cream parlors would not achieve this result. Neither would two halves of soup shops. Another force, in this case the weather, drives returns in the same direction for all ice cream parlors. The fact that the outside force has a positive effect on ice cream demand and a negative effect on soup allows you to diversify.
Diversification means that for the same return, you can lower the risk. An alternative way to think of it, is for the same level of risk, you can get a better return. It’s no wonder that the Nobel-Prize-winning economist Harry Markoitz famously said, “Diversification is the only free lunch.”
The group of assets you’ve purchased is called your portfolio. A “balanced” portfolio is one that has spread its eggs well.
If you knew what would happen, you wouldn’t diversify — you would invest 100% of your money in the asset that would yield the highest return. If you knew it would be sunny, you would only buy the ice cream parlor. If you knew that one stock would triple over a year, you would put all of your money into that one stock. If you knew that real estate in your area would be flat, you wouldn’t put 100% of your net worth into a house.
But no one can predict the future perfectly. You’re always going to have limited information, and unforeseen events can have a huge impact. You cannot predict the markets. You’re going to make mistakes. But if you diversify well, your wins will outweigh your mistakes massively.
While it is highly unlikely that you’ll have 100% winners, you want to select assets you believe are all 100% winners. Really try to never be wrong. Even when you try your best, you will still be wrong sometimes (those are great opportunities to learn). A portion of investments either won’t go anywhere or even drop in price, but you need to ensure they do not account for your whole portfolio. Part of diversification is that what isn’t gained in one place is more than made up elsewhere.
You have made a mistake if your portfolio has a negative return.
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