by WWM | Feb 27, 2019 | Asset Classes, Risk, Target Asset Allocation
The core asset classes have general risk-return characteristics.
The greater an investment’s risk, the greater the demanded return by investors.
Cash is low risk, low return. Fixed income is riskier and has higher returns than cash. Common shares have the highest risk and expected return of the core asst classes.
But you need to exercise care when selecting investments within a specific asset class. There can be significant fluctuations in risk-return profiles between investment options in each class.
We will look at a few examples today.
Cash and Cash Equivalents
In general, cash equivalents are considered low risk and low return assets. They are known for their safety and liquidity.
But not all cash equivalents fit this profile.
For a U.S. resident investing in short-term U.S. Government Treasury bills, those characteristics hold true.
High Risk Countries
But the Venezuelan bolívar is also cash. For a U.S. resident investing in bolívar during 2018, the hyperinflation in Venezuela made this currency worthless.
Or consider the Argentina peso. In 2001, the government effectively froze bank accounts for a 12 month period. In large part, liquidity and safety disappeared almost overnight. As an added bonus for Argentines, prior to January 2002 the peso was pegged to the U.S. dollar (USD) at a 1:1 ratio. Then one day Argentines awoke to find the conversion rate re-pegged at 1.4:1. Within short order that re-pegging had fallen to about 4 pesos per U.S. dollar.
What did that mean?
If you bought a USD 600 television imported from America, it cost 600 pesos in December 2001. Less than a year later that same purchase cost 2400 pesos.
Be careful of countries that have a high risk of heavy inflation or the potential for intentional currency devaluation.
Even Low Risk Countries
If you think it is simply countries such as Venezuela and Argentina that need watching, check out the 10 year exchange rate changes between the U.S. and Canadian dollars. Or the USD and the Euro. Or other major currencies. There can be some large swings in exchange rates.
For example, I was living in Switzerland when the Euro was introduced. In 2001, the Euro was usually worth between USD 0.80 and 0.90. By late 2004, each Euro was worth USD 1.36. If you were an American and had bought Euros in December 2001 at 0.88, by December 2004 you would have earned a 55% return.
And if you were living in Euroland and had invested in USD between those years, you would have lost a lot of money.
Two highly regarded currencies. Yet not a low risk, low return investment, was it?
When investing internationally, whether to hedge your foreign currency is always a concern. There are pros and cons to hedging (or not). What is preferable for one investor will differ from the next. And there are multiple variables that require consideration before deciding if hedging is right for your portfolio.
Fixed Income
Fixed income securities are generally considered to be higher risk and higher return than cash equivalents. But lower risk and return to common shares.
Yet again, individual fixed income securities can differ from this generality.
Credit Rating
Fitch Ratings classifies the “safest” bonds at AAA. Lowest investment grade bonds are BBB. Bonds in default are rated D.
As you would expect, the higher the bond rating, the lower the risk of the bond not paying interest on its debt and in the repayment of principal. The lower the risk, the lower the interest that is needed to attract investors.
Conversely, the greater the risk that the bond issuer will be unable to pay the interest and principal, the more incentive is required to attract investors. That incentive could involve “sweeteners”, though often it is simply offering higher yields.
For example, consider four bonds, maturing in 18 years, with no sweeteners or provisions. Data as at February 26, 2019.
Government of Canada 5.00% 01-Jun-2037 are rated as AAA. The yield to maturity (YTM) is 2.074%.
Hydra One Inc. 4.89% 13-Mar-2037 are rated as A (High). The YTM is 3.628.
Bell Canada 6.17% 26-Feb-2037 are rated as BBB (High). The YTM is 4.258%.
Shaw Communications Inc. 6.75% 09-Nov-2039 are rated as BBB (Low). The YTM is 4.834.
You can readily see, as the risk of default increases, the yield to maturity required by investors also rises.
Equities
Of the three core asset classes, common shares traditionally have the highest risk and return.
But this may not always be true.
Other Asset Classes May Outperform
We looked at some fixed income yields above. Assuming a hold until maturity, yields between 2% and 4.8%. Relatively safe, but also relatively low return.
What if we compare this to Canadian equities?
On February 27, 2018, the TSX Composite closed at 15,671.15. On February 25, 2019, it closed at 16,057.03. A one year return of only 2.68%. Lower return than many bonds, yet much higher risk.
Of course, one year is a very short time frame. Too short to properly assess higher risk assets. Over the 10 years ended February 25, 2019, the TSX Composite earned investors more commensurate average annual returns of 7.31%.
Never focus on short term performance for higher risk investments.
Differences Within the Class
Of the three core asset classes, there are the most subclasses within common shares.
Mega cap shares will normally have less risk and return than micro or nano cap companies.
Value stocks may be less volatile than growth stocks.
Dividend producing companies may be lower risk than capital appreciation shares.
Foreign companies may have more risk than domestic.
Defensive stocks may be less risky than cyclicals.
Mining companies may be riskier than utilities.
Or, depending on economic conditions, the opposite may be true.
The individual common shares you select will have a different risk-return profile than common shares as a whole.
That is why investors often diversify through multiple subclasses, to spread the risk. Or purchase exchange traded or mutual funds, that usually contain a substantial number of individual investments to diversify risk somewhat.
That is also why some investors try to time the markets. As one subclass begins to outperform, more capital is allocated to that subclass and away from underperforming subclasses. But the ability to time the market is not easy and the transaction costs can be steep. Many investors get the timing wrong and end up costing themselves return.
Okay, that was a few quick examples of how investments within a specific asset class may differ significantly from the general profile for the class as a whole.
There are many other examples possible, but this gives you an idea as to what I am saying.
by WWM | May 10, 2017 | Risk
Becoming an effective investor requires you to properly manage investment risk.
Today we shall look at how this is typically done.
Previously, we reviewed ways to manage pure risks in daily life. These included: risk retention, risk avoidance, risk transfers (including insurance), and loss control.
Some of these tools may also be used to address investment risks. While risk retention may be used, it makes little sense to review in an investment context, so we shall skip any discussion of it.
Risk Avoidance
In some circumstances, you can use risk avoidance to eliminate or minimize the potential impact of certain systematic and nonsystematic risks.
A hurricane is a systematic risk. While you cannot avoid the impact on companies affected by the hurricane, you could avoid investing in companies that operate in hurricane belts, such as the Caribbean or Gulf Coast.
The same applies for political risk. If you have concerns a country may nationalize assets of foreign companies, excluding investments in companies that operate in that country would eliminate this risk. General Motors is a good example.
Management risk is a nonsystematic risk. If you worry about the next Kenneth Lay managing one of your investments, you can avoid buying shares in public companies. Instead, you could invest in money market funds or term deposits to eliminate management risk. Of course, you still need to worry about the fund company and bank.
Investors with extremely low risk tolerance may use this technique to avoid many risks. Unfortunately their investment options are limited and their returns will be low.
Additionally, there are certain risks that cannot be avoided.
If you invest in US government Treasury Bills, you do not (as of this date) have to worry about management or credit risk. However, the risk of inflation can impair or even destroy your invested capital. A decrease in interest rates may create reinvestment risk. Or, a weakness in the US dollar may result in currency risk. And so on.
With each potential investment there are specific risks you can avoid. But also other risks that cannot be avoided.
And each investment will have a different combination of avoidable and unavoidable risks.
Not good, is it?
Well, as we shall see later, this actually has its advantages for investors.
Risk Transfers
Financial markets do a good job of allowing investors to effectively transfer risk to others.
Hedging can reduce risk by transferring risk to other investors or speculators. In fact, that is a key function of speculators. They accept risk from those who wish to hedge their activities.
There are different methods to hedge ones risk exposure in investing.
In addition to pure hedging actions, the use of swaps, derivatives, and other more complex financial transactions can be used to alter the risk-return profile of investments.
An example of a risk transfer is a capital protected mutual fund. This type of fund invests in different investments (e.g. S&P 500 fund, bond fund), yet the fund guarantees your invested capital from loss. Some funds guarantee 100% of your capital, others 90% or less.
The attraction is that you are able to participate in the upside return potential of the underlying investment. Yet you are protected from any downside risk of monetary loss. Note that this would be an example of an asymmetric return profile that we looked at in our limitations of standard deviation discussion.
Pretty good. Risk of outperformance, but no risk of loss.
Of course, there is a cost associated with transferring the downside risk elsewhere. The greater the percentage of capital that is guaranteed, the greater the cost. Depending on the investor, that cost may make these investments unattractive.
There are a variety of ways to create a fund such as this one. Combining a Treasury Bill and a call option is one simple method. However, these are advanced techniques that are outside the scope of our discussion.
We will look at risk transfers, in brief, at a later date.
Loss Control
Loss control involves identifying all risk factors present and attempting to minimize or eliminate the key risks. For key risks that cannot be minimized, one tries to reduce the potential loss should it arise.
The first step is, in part, dealt with above in risk avoidance.
The second step involves prudent investment practices.
Prudent Investment Practices
One important measure is in understanding how to invest.
Hopefully this investment series and ongoing commentary will provide some pointers.
One can also take courses that provide the basics for investing. Many on-line brokerage firms and banks provide internet tutorials and webinars as well. There are many options for improving one’s knowledge on how to invest.
A second measure is to undertake proper research before investing one’s capital.
We will look at investment analysis in detail later this summer. It is not that easy a task. I think it requires some expertise in finance and accounting to properly analyze traditional investments.
For non-traditional investments such as art, collectibles, and even real estate, you also require strong knowledge about the asset itself.
Since I was young, I collected coins. I have some knowledge of them as an asset class and investment. But I know nothing about stamps, so I would never invest directly in stamps.
In fact, I would be leery of seriously investing in coins as well. While I have some knowledge, I could not successfully compete against experts in the field.
I would never play golf against Rory McIlroy for money. Similarly, I would never compete against experts in any other area unless I was equally proficient. If you do, you are playing a fool’s game.
That said, if you learn how to research investments, you can glean valuable information concerning potential risks.
Perhaps you worry about legal or credit risk. You can get clues about the likelihood of these risks arising through analysis. Financial statements, corporate releases, and news items will provide information concerning past, ongoing, or potential litigation. I always find that the best information is buried deep within the notes to the financial statements.
A review of the business can also provide hints for potential problems.
For example, mining and offshore oil companies run a risk of accidents and environmental damage that may result in litigation. Look at Massey Energy or British Petroleum in 2010. Contrast them with Apple. Yes, there may be other legal issues for Apple, but Apple investors need not worry about mine collapses or oil spills causing losses on their shares.
Financial analysts’ reviews and recommendations can also help you find investments that may perform better than average. Not necessarily so, but a good place to begin your own analysis.
A third measure in controlling risk is through your portfolio construction.
The keys here are diversification and asset allocation.
I think that asset allocation is diversification, but most people separate the two, so I shall follow suit.
Diversification and asset allocation are extremely important for investment success.
We will save asset allocation for when we discuss portfolio construction.
But next up, we shall take a detailed look at diversification.
by WWM | May 4, 2017 | Risk
Managing risk is extremely important in daily life, as well as in business and investing.
Today we look at five key ways to manage pure risks. These include: risk avoidance, loss control, risk retention, non-insurance risk transfers, and insurance.
While the terminology may be new, you utilize some or all of these techniques on a daily basis. So this is just a refresher.
Risk Avoidance
By avoiding a specific risk, you attempt to eliminate it entirely.
Certain risks are relatively easy to avoid. You can completely avoid the risk of divorce by never getting married. Or you can eliminate the risk of a shark attack by never going into an ocean (and watching out for Sharknados).
Some risks, like death, cannot be avoided, no matter what actions are taken.
In between these two extremes lie the majority of risks that impact life on a daily basis. These risks can only be avoided provided you are willing to sacrifice much of your existence.
For example, you can eliminate the risk of an automobile accident by not owning a vehicle or ever riding in one. Or you can avoid being mugged on the street by never leaving your home.
For most people, this is not a practical, nor enjoyable, way to manage risk.
Loss Control
Loss control works in two ways.
First, loss prevention is used to to assess the probability of risk. The specific factors that make up a risk are identified. Then actions are taken to eliminate or minimize the key factors.
Second, for those risk factors that cannot be eliminated or minimized, steps are taken to reduce the loss that will be experienced should the risk occur.
Consider the factors involved in an automobile accident. They include: driver skill, driver issues (e.g. intoxication, tiredness, poor eyesight), vehicle road-worthiness, road conditions, volume of traffic, the actions of other motorists, etc.
Some loss prevention measures may avoid certain of these factors.
By ensuring that your vehicle is always in excellent condition, you substantially reduce the risk of mechanical problems. If your signal lights are operational, you minimize the risk that other drivers cannot determine your intentions. By only driving while sober, you eliminate the risks involved with driving while impaired.
Other risk factors can be somewhat reduced but not eliminated.
You could take a driver training course to improve your skills and confidence. When driving in winter conditions, you can ensure that you are using snow tires to assist with the icy roads. You can drive primarily at times when the roads are less congested and not during rush hour.
While these actions help reduce the probability of having an auto accident, they do not entirely eliminate the possibility. This is where loss reduction comes into play.
Realizing that a loss may arise regardless of one’s (reasonable) actions, you can try to minimize the physical, emotional, and monetary damage done.
Driving at a speed appropriate for the conditions is one example. It reduces the odds of an accident (loss prevention), plus it may reduce the actual loss if there is an accident. The financial cost of an accident and the personal injury should be less at lower speeds.
A seatbelt is another way to reduce loss. If you get into an accident, it is usually safer for those wearing a seatbelt.
Avoidance and Loss Control are active measures to eliminate or minimize risk.
There are three financial ways to also manage risk: risk retention; non-insurance risk transfers; insurance.
Risk Retention
Risk retention is the managing of risk internally. It is accepted that there is a risk involved in all activities. The company or individual assumes responsibility, in whole or in part, for the potential damage that may occur from the risk.
Risk retention occurs because alternative risk management tools are not available or they are prohibitively expensive.
For companies that retain many of their own risks, this is called being self-insured.
Because of the high cost and uniqueness of many corporate risks, more and more businesses self-insure.
Individuals also engage in risk retention. In fact, everyone reading this post is retaining some risk at this very moment.
Automobile insurance is a good example of risk retention in everyday use. Within the contract, there is usually a deductible (or “excess” in some countries). If it is $300, then you pay for the first $300 on any claim before the insurer covers the remainder. In effect, you have retained the risk for any damage up to $300.
Deductibles are common in medical, dental, and travel insurance as well for individuals.
The other thing to notice with an insurance deductible is that the amount will affect your premiums. If you assume a greater percentage of risk by moving your deductible to $600, your ongoing premiums should decrease. Conversely, if you reduce your deductible to $50, you will see an increase in your premiums.
The greater the risk you retain, the less you should pay to transfer the remaining risk to another party. That holds true for standard insurance, but also in respect of investment risk. As we will see over the next while.
Non-insurance Risk Transfers
These transfers typically involve either contracts, hedging activities, or incorporation.
Contractual Risk Transfers
Through a contract, risk may be transferred from one party to another.
For example, you buy a new MacBook from Apple. The computer comes with a one year limited warranty as part of the purchase price. Hopefully the life of an Apple computer exceeds one year, especially at the prices Apple charges. So what happens if your computer crashes in the thirteenth month? Or thirty-third? After twelve months, the risk is all yours.
However, AppleCare offers the ability to extend the initial warranty for an additional two year period. This contractually shifts the risk of loss through certain damages to Apple for the agreed upon period.
When contractually transferring risk, be sure to know exactly what is in the contract.
A “limited warranty” is so named because it is limited in scope. While you transfer some of the risk to another party, chances are there are key risks that you retain.
AppleCare’s limited warranty does not cover “damage caused by accident, abuse, misuse, liquid contact, fire, earthquake, or other external causes”. Abuse and misuse are nebulous terms that make filing successful claims more difficult.
As an aside, there is a great example within the Apple exclusions. The last Applecare terms and conditions I reviewed stated “flood” and not “liquid contact”. Exclusions within insurance contracts seldom improve over time for customers.
This is another general rule to always remember. The party that writes the contract usually gets the best of the terms. If signing on to a standard contract that you cannot amend, you will normally be at a disadvantage when problems arise.
Determine the “exclusions” in any contract before deciding to purchase it. The risks you actually transfer may not be worth the cost. In the case of a MacBook, sure you may get a lemon. But you will notice within the original 12 month warranty period. You are much more likely to drop your MacBook, spill coffee on it, or have your cat scratch the screen. Actions that are not covered in the extended plan.
You must decide if the probability of something happening that is covered is worth USD 349.00 for two additional years. Ensure you know exactly what is covered and what is not. Then decide if it is worth the additional cost. Often it is not.
Hedging
Hedging activities may also serve to reduce risk. It is especially useful when addressing portfolio risk.
We will consider hedging in much detail at a later date.
Incorporation
Finally, a corporation or limited liability company may be used to reduce personal risk.
For example, you run both a landscaping business and a home building business as separate sole proprietorships (i.e., unincorporated). Landscaping has become a very lucrative business and you earn $100,000 annually from it. Unfortunately, your goal of building window-less houses has not fared as well. In fact, your creditors are taking you to court for unpaid bills.
Since both businesses are sole proprietorships, creditors will be able to attack you personally to get their money. Although your landscaping business is entirely separate, the home building creditors will take those profits.
However, if both businesses had been incorporated, with some important exceptions, the creditors of the home building business may be unable to take money from the landscaping company.
Note that this is a simple example. As more individuals incorporate to limit their personal liability, there are additional options for “piercing the corporate veil” and attacking the actual owner for his actions.
Insurance
We saved the obvious and most widely used risk management tool for last.
Insurance is used by individuals, businesses, and other organizations to offset many risks.
Premiums are paid to an insurance company. In exchange, the insurer assumes the pure risk and agrees to pay a certain amount should a loss arise.
Like any contract, be certain to know the “exclusions” in any insurance coverage. Often people are surprised by what is not included.
We will look at insurance in greater detail later in the series. As I am certain that almost everyone has dealt with insurance companies on some level, our focus will be more on life related insurance topics.
Which Tools Should You Use?
Whether in your personal life, business, or investing activities, you will use each of these tools in some combination.
What is the best combination for one person, may not be right for another.
As we discussed with risk in general, each individual’s risk tolerance may differ.
Extremely risk averse individuals may want low deductibles to cover every problem. They purchase extended warranties on products. In exchange for greater peace of mind, they willingly pay a premium for additional protection.
Those who are extremely risk tolerant will never buy extended warranties and carry high deductibles. In business, they will self-insure. They believe money saved on insurance premiums over time will more than offset any future losses.
How you combine these tools is completely at your discretion.
How have you already used these tools in your life?
Your views and actions will help you to understand your own personal level of risk tolerance.
It is important for investors to learn about themselves. How one invests is usually a function of one’s risk tolerance.
We will look at investor risk profiles in the near future.
by WWM | Apr 26, 2017 | Risk
The complement of nonsystematic risk is systematic risk.
Systematic risks affect an entire market or a specific segment of that market.
Systematic risk factors are far reaching and impact all companies to some extent. These factors are not unique to the investment under consideration. They will harm a company regardless of how the company operates or manages its risks.
Systematic risk may also be known as nondiversifiable, non-controllable, or market risk.
In this post we will review a few key systematic risks that often affect investors.
Note that it is not an exhaustive list.
Interest Rate Risk
Interest rate risk reflects how changes in interest rates may affect a company or investment.
Individual companies have no control over interest rate fluctuations. Interest rates move based on a variety of high level factors, including: governmental monetary and other policies; Central Bank actions; supply and demand of money and credit; general economic conditions.
A company’s actions do affect their own credit worthiness and the rates that they pay relative to the benchmark (Prime, LIBOR, etc.) but they have no material influence on the benchmarks themselves. That is why interest rate risk is a systematic risk and not a nonsystematic risk.
Why is interest rate risk an issue for companies and investors?
As interest rates rise, the cost of borrowing increases for companies.
For example, last year a $10 million bank loan may have resulted in a 5% variable interest rate. So a company would have paid the bank $500,000 in interest. If general interest rates rise to 8% this year, the company will need to pay the bank $800,000 in interest payments.
That is $300,000 less money available for reinvestment in the business, paying suppliers and other creditors, or being available for interest or dividend payments to investors.
It is also $300,000 less in profits. Earnings are often a key figure used to value companies. With less earnings, the company and its public shares may also be worth less.
Inflation Risk
Inflation risk is the risk that the price of goods and services will rise, thereby reducing the purchasing power of your assets. Inflation risk is usually linked with interest rate risk as interest rates will normally rise as inflation increases. Or rates will rise as governments or central banks attempt to contain inflationary pressures.
Imagine that you need to purchase a specific set of textbooks, materials, and supplies for school in six months time. You can buy them all today for $1000 or you can wait until the school semester begins. You notice that your bank is offering a six month term deposit with a 3% return for the period. You figure that an extra $30 in interest will buy you a few coffees on campus, so you deposit your money with the bank.
Over the next few months you read in the paper about concerns in the Middle East impacting oil prices. The economy is also heating up and the newspapers are using the word “inflation”. A concept that was covered in the economics class you missed with a hangover.
When the semester starts and the term deposit matures, you take your $1030 and head to the local coffee shop with a stop at the bookstore on the way. You collect all the required items and go to the checkout to pay the $1000. You receive a bit of a shock when the bill totals $1050. Not the $1000 that it should have been.
The clerk, by coincidence an economics graduate, explains that during the past six months inflation has rose 5%. As a result, the general cost of living has increased and goods cost correspondingly more money.
That is inflation risk. Unless the return on your assets meets or exceeds the inflation rate, the value of your assets will fall.
As an investor if you invest your cash in fixed income instruments, you need to be aware of expected inflation rates. This is why “real return” is a very important benchmark.
For example, in late 2008 I could recommend an investment that would easily double in 30 days. In fact I would guarantee that return. Sounds good, no?.
But what if I told you that the investment was based in Zimbabwe which was experiencing a monthly inflation rate of 79,600,000,000% (no, not a typo). At that rate, prices double every 24.7 hours.
Even though you would double your Zimbabwe dollars in one month, they would have lost their entire purchasing power in only one day.
While the rest of the world may not be Zimbabwe, on smaller scales this regularly occurs.
Be careful.
Reinvestment Risk
Reinvestment risk arises primarily due to the impact of interest rate changes.
It is the risk that total returns are altered due to a shift in interest rates.
For example, you have $10,000 that you intend to invest for 5 years in a Guaranteed Investment Certificate (GIC) issued by your bank. You can purchase a 5 year GIC that offers a 5% compound interest rate. However, you notice that the 1 year GIC offers a 7% rate. You decide to buy the 1 year GIC now and then purchase another at the end of the year.
At year end you receive $10,700. You reinvest in another GIC, but the best rate you can find is for 1 year at 4%.
That is reinvestment risk. The risk that when you go to reinvest your income you cannot obtain the same rate as you received on the initial amount.
This is a common issue for bond or dividend income.
In much of the world today, this is a real problem for retirees who live on fixed income from investments. As interest and dividend rates fell, income for retirees also decreased. And while inflation in North America has not been a major factor, prices never go down. This has caused financial difficulty for many of the elderly.
Like all risks though, there is potential upside to reinvestment risk, not simply downside.
Perhaps you own a 30 year bond paying 3% annually in cash interest payments. There may be periods during which market interest rates rise and you are able to reinvest at higher levels.
When we look at fixed income investment strategies, we will consider methods to address reinvestment risk. If you cannot wait, google “fixed income ladder” for one simple and effective method.
Currency Risk
Each country has a currency with which goods and services are paid.
Some countries share a common currency.
A single currency, the Euro, is shared by 19 of the 29 European Union Member States. The Euro is also the official currency for a few additional smaller countries, states, and territories.
Some countries maintain their own currency but have it “pegged” (i.e. linked) to another country’s currency. The pegging may be a one to one ratio or something completely different.
The Bahamas pegs their currency on an equal basis to the US dollar. In fact, payments can be made in either currency without a problem. And when you get money back, it can be a mix of Bahamian and US dollars. In the Cayman Islands (CI), 1.00 CI dollar is pegged at 1.227 US dollar (1.00 USD = 0.80 KYD). Payments may be made in US dollars at the official exchange rate, but any cash returned will be in CI dollars (there are a few exceptions in certain tourist shops).
Other countries take the pegging concept a step further and actually adopt the currency of another country. For example, Ecuador eliminated its own currency and adopted the US dollar as its official currency.
Finally, some countries let their currency “float”. A specific currency will float like a boat on the ocean. The country’s economic fortunes, as compared to its own expectations and the forecasts of other countries, will rise and fall over time. The country’s currency, by its movements, should reflect these relative changes in prosperity.
Well that is the theory. In reality, individual countries attempt to control the value of their currencies based on premeditated actions taken by the country and/or its central bank.
Currency risk can greatly affect investors in the global marketplace.
Perhaps you are an American investor who buys CAD 10,000 in 5 Year Government of Canada bonds with a 6% coupon interest rate paid annually.
Being an American investing in Canada you must consider both base and local currencies.
The base currency is usually your own domestic currency. The home market in which you operate. The local currency is the currency of the foreign market in which you are investing. In this example, the American’s base currency is the USD. The local currency is the CAD.
Note that for a Spaniard investing in a Moscow real estate project, the base currency is the Euro and the local currency the Russian ruble.
At the time of the investment, CAD 1.00 equals USD 0.80, so you pay USD 8000 for the bonds. Over the 5 years you will receive annual interest payments of CAD 600 and after 5 years, you will receive CAD 10,000. Cumulatively you will have received CAD 13,000; CAD 3000 in interest and CAD 10,000 in repayment of capital.
But what if the CAD has depreciated over the 5 year investment period? At the end of each year the CAD/USD exchange rate is 0.75, 0.68, 0.73, 0.64, 0.58. The interest you receive, assuming you immediately convert it back to USD, will only amount to USD 2028. The maturing bond will be worth USD 5800. This results in a total return of USD 7828.
You actually lost money on this simple fixed income transaction.
Thieving Canadians!
Sociopolitical or Geopolitical Risk
The risk that instability in one or more regions of the world negatively impacts investments. War, terrorism, health scares are examples of this risk.
Wars in Africa continually impact markets in the region and spill over to international companies and consumers who rely on those markets and products.
Consider the global market reaction to the September 11, 2001 terrorist attacks. Regardless of the industry or company, there was a high probability the company’s shares fell that day.
Or how about the Severe Acute Respiratory Syndrome (SARS) scare in 2002. There was a tremendous impact in companies operating in Asia (and certain other areas), not to mention on tourism and export operations.
Individual companies had done nothing different in their operations. But the above risk occurrences may have had significant impact on their business and profitability.
That is an overview of both nonsystematic and systematic risks.
I hope you found it interesting and informative.
Next we shall look at the generic tools available to address risk in business.
After that, consideration of how to address risk as an investor.
Then we shall move on to looking at investment returns and asset classes.
by WWM | Apr 19, 2017 | Risk
Previously we looked at liquidity risk for marketable securities. Stocks, bonds, and the like.
Today we shall review liquidity risk factors for physical assets.
I shall limit this to an overview for two reasons. One, we will consider physical assets in greater detail when we look at the various asset classes. Two, investing in physical assets can be quite complicated. It is an area probably more suited for experienced investors with substantial wealth. Therefore, it is out of scope for this initial investing series.
For purposes of this post, physical assets shall be those “hard” assets that you can physically hold in your hands. These include: real estate, gold, diamonds, fine art, stamps and coins, wine.
We will alter the definition when we look at these assets in more detail. As we shall see then, often one can invest in these assets and never take actual possession. But for now, the term fulfills our needs.
There are also “bankable” assets. Assets held by your bank or brokerage on your behalf. Rarely does one take physical possession, although it is possible (but not usually prudent). These include investment certificates, stocks, bonds, etc.
Physical assets tend to have many problems associated with them as investments. Liquidity being a large one. Here are a few things to consider.
How is the physical asset bought and sold?
Physical assets are significantly more difficult to trade than bankable assets.
Trading markets may be non-existent or extremely inefficient. By inefficient, I mean that any existing market does a poor job of: a) bringing the maximum number of buyers and sellers together; b) readily determining market value for the asset.
When there is no easy way to bring buyers and sellers together, trading suffers.
Perhaps you wish to buy your spouse a ring made with his May birthstone, an emerald. You know exactly the quality and size that you want. If you live in Regina, your buying options may be limited. You can go to the local jewellery stores and pay the prices they offer for whatever inventory they may have on hand.
Meanwhile, Juan’s Jewellery in downtown Bogota, Colombia has exactly the ring you are seeking, but at one-third the price you must pay in Regina. The price difference is due to a variety of factors – labor costs, transportation, import duty, and the fact that Colombia produces fine emeralds itself.
Unfortunately, unless you are in Bogota, it may be difficult to determine that Juan has much better deals than are possible in Regina. This is because there is no formal market bringing buyers and sellers of emerald rings together from around the world. If there was, both you and Juan would benefit.
This tends to be a drawback for physical assets.
Even if a markets exist, the market itself takes a healthy share of the proceeds.
Consider the world of fine art investing.
Art transactions usually occur through dealers or auction houses. While commissions are often negotiable, an auction house may add 20-25% to the buyer’s price as a buyer’s premium. There may also be a commission or fee charged to the seller. This is financially dangerous if you want to trade quickly.
For example, you acquire a painting for $1.5 million. Sotheby’s, a major auction house, charges you $300,000 as a purchasing commission. One month later, you have a major financial crisis and need to sell the painting at auction.
The market is stable and you are able to find another buyer at the $1.5 million you paid. Unfortunately, Sotheby’s charges you a sales fee of $100,000 on the transaction.
While you bought and sold at the exact same price, you lost $400,000 (27%) on your investment. And that $400,000 loss did not factor in other costs associated with art trades, including: shipping, storage, insurance, marketing.
Sadly, in the real world of auction houses, the figures in my example are probably not far off.
As a rule, the fewer options you have to trade, the more you will pay in commissions or fees.
While I used art as an example above, I could easily substitute stamps and coins, collectibles such as porcelain dolls or rare books; pretty much anything that can be bought and sold.
On the positive side, the internet and companies like eBay are improving the efficiency in trading physical assets. But that is a slow process and comes with other risks (for example, dealing with Sotheby’s rather than Joe in Vermont).
How homogeneous is the asset?
Physical assets tend to be heterogeneous. That is, each individual asset is unique from others in its class. Obviously, the amount of uniqueness can vary greatly between assets.
Randomly take 10, 1 carat diamonds to a jeweller and see how homogeneous they are in quality. There are likely significant differences between them that greatly impact their relative value.
Some items like gold, in bullion or coin form, are somewhat easier to evaluate. The keys being the gold content of the item and current price of gold. If a coin, there might also be some consideration given to any numismatic value.
But what about the Mona Lisa painting? There is only one of this asset. How can it be compared to any other piece of art?
The less homogeneity, the more difficult the valuation.
Even for relatively homogeneous assets, each can differ in quality.
You turn 50. Suddenly you need a new 2017 Porsche 911 Turbo S. You go down to the local dealer, but none are available. You are not getting any younger, so you order one directly from the factory in Zuffenhausen, Germany.
Because it is a new vehicle, there is a high probability that every 911 will be almost the same. Still, when it finally arrives, you will want to check it for scratches, etc.
You also want to make certain that Gunter and his auto assemblers were alert the day your car was built. In rare cases, usually timed around German World Cup Football matches, mistakes are made and one or two “Zitronen” are created.
Time can also create differences between homogeneous assets.
In three years, when you attempt to sell the Porsche, potential owners will be more careful in their review than you were with the new vehicle.
Did you have an accident and replace the front end? Did you drive up and down the Autobahn (or rural roads) everyday, putting 300,000 kilometers on the engine? Or did you simply drive it to and from the grocery store once a week and only have 5000 kilometers on it?
Review 100 2017 Porsche 911 Turbo S in three years and you will find a wide range of values for the cars.
What is the quantity of the physical asset?
Like financial instruments, the rarer the physical asset the less likely you can find a seller, although there may be many buyers available. Greater demand than supply will lead to price increases.
Also, with less assets in the market, there will be less trading. This leads to less publicly available information on recent pricing. Less publicly available information leads to less value and pricing transparency.
If Citigroup traded 18 million shares yesterday, that is a lot of shares trading hands. If you own 1000 shares, you should be able to sell them quickly with little impact on prices.
But how often are Monet or Renoir paintings bought and sold? Much less than 18 million times each day (or century). The lack of available buyers, sellers, and recent pricing information makes valuations much harder.
How easy is it to value the physical asset?
The greater the volume of trades, the more information is available to potential traders as to the value of an asset at a given point in time.
The less trading, the less public information, the more expertise a trader requires to arrive at the proper value.
In trading 18 million shares daily, Citigroup is relatively easy to value at its close of USD 58.99 on April 17, 2017. And with the daily range on April 17 between USD 57.925 and 59.06, I have an strong sense of where Citigroup will open Tuesday (assuming no material news is released overnight that roils the markets or company).
But for smaller public companies, there may be significantly less shares outstanding and lower trading volumes. The volume of the bid and ask prices is as important as the actual prices themselves. Further note how tight the bid-ask spread is for this financial instrument.
If you wish to buy or sell a residential house, it is more difficult. You would examine “comparables” (or “comps”) to the property you are evaluating. While not an exact comparison, knowing the value of homes that have been recently sold that share similar characteristics with the property you are evaluating, greatly assists the valuation process.
Your information will definitely be less than 18 million home sales. But for many cities you can usually arrive at a decent valuation based on comparable properties sold.
Now imagine living in a community where the last house was sold 30 years ago. Finding comparables to assess your property becomes extremely difficult. That is the case with fine art. One study found that the average time to market (from sale to next sale) is about 30 years. In some cases, 100 years is reasonable and some art never re-surfaces on the open market. Makes it very difficult to correctly determine fair market value.
Expert knowledge of the physical asset is crucial.
To (hopefully) prosper in this investing realm requires an expertise in the specific asset.
If you are buying (or selling) a rare coin, you need to know at least as much as the person selling (or buying) it to you. Otherwise, you will be taken to the proverbial cleaners.
Again, the need for market specific expertise is necessary for all physical assets. Unless you have that expertise, I do not recommend directly investing in most physical assets.
That said, there are ways to indirectly invest in physical assets. As we shall see later, this can be beneficial to most investment portfolios. But that is a conversation for a later date.
For the moment, that concludes our look at physical assets.
And it also ends our discussion of liquidity and other nonsystematic risks.
Next, we will look at systematic risk factors.