Sources Of Risk In Investment – No One Is Safe!
The topic of risk is one that I can find myself ranting about if I’m not careful. I feel quite strongly that the word risk is used irresponsibly in most discussions around investing. There are many sources of risk in investment, and millions of people around the world are dumping money into what they believe to be perfectly safe investments, completely unaware of their risks.
The truth is that there’s no such thing as a completely safe investment. Each investment has a unique mix of risks.
Even U.S. treasury bonds and depositing money into a checking account carry plenty of risk. So let’s get started.
How I Define Risk
I think the word risk is used to discourage people from partaking in good investments. You can have a conversation with a friend or family member thinking that real estate is an incredibly risky investment, even if that person has never bought a house!
Here is my definition of risk:
Anything within or outside your control that can turn a good investment into a bad investment.
What does that mean?
Well to me a good investment is one that beats inflation over time, and a bad investment is one that loses to inflation over time. Since the average inflation rate is about 3%, a good investment gets at least a 4% return over a long period of time. And a bad investment is anything that gets a 3% return or worse over time.
This means, by my personal definition, some investments are bad no matter what you do. If you invest in a U.S. treasury bond today, it’s impossible for you to get more than 2% return on investment. It’s bad from the get go, and this is what the average American considers one of the safest possible investments.
They say “you can’t lose money with a bond,” and I say it’s impossible to not lose money with a bond. You’re money is losing buying power over time because of the effects of inflation. That’s as good as losing money.
Quick List Of Investment Risks
Here’s a list of the most important risks for investors to know.
Inflation risk – As the cost of goods and services increases over time, the value of money decreases. Investments need to at least keep pace with inflation or they’re losing you money.
Debt risk – When you assume debt in order to purchase an investment that will assist you in making the debt payments, there is a risk that the investment will no longer support those payments and you’ll go bankrupt.
Legal risk – Some investments create a liability where you may be responsible for abiding by certain laws. Breaking those laws can result in a lawsuit that may cost you a lot of money. Also, if your investments are affected by local laws, your profitability can be killed by new ordinances.
Tax risk – Some investments have huge tax benefits while others will land you with a large tax bill at the end of the year.
Ignorance risk – Sometimes the biggest risk for an investor is taking action without having enough information. There may a huge mistake that was completely avoidable with the right knowledge.
Timing risk – Sometimes you are at the mercy of the times and the returns during your time are lower just because of when you were born. Also, you can choose to put your money into an investment and pull it out at the wrong time and lose money.
Holding risk – Some investments hold your money hostage and only allow it to be accessed at certain times without penalty.
The Biggest Investment Risk
I believe ignorance is the number one investment risk in the world, and it’s running absolutely rampant.
The majority are “investing” their money wherever they’re told to invest. They don’t actually know where their money is going and how it’s being invested. They don’t know what would cause their money to grow and what would cause it to shrink. Most people are engaging in the riskiest possible style of investing, the kind where you don’t know what you’re investing in!
No one is looking out for you
Mutual funds are the most common investment option offered for a 401k. Mutual funds are pools of investors’ money that is invested by a fund manager. They are supposedly an expert and they will invest your money to get maximum returns for you.
The problem is mutual fund managers are not paid based on how well their investment decisions turn out. They are paid based on how much money they manage. If their investors lose money, they still make money.
Further, because they make money based on how much money they manage, their most important metric is their return over the last quarter and the last year. They generally make investment decisions based on what will have the biggest short term returns, not long term returns.
It’s a sales tactic. They are able to convince more investors to put money into their fund by showing off their short term return numbers. And when more money comes into the fund, they make more money. Remember, they don’t make money when you make money.
That’s where most Americans are putting their money. They’re putting it in the hands of someone who doesn’t have their best interests in mind.
Ignorance is bliss
So most will send their money to someone else, hoping that when they check on their money again in 20 or 30 years, it has grown to an adequate level.
I think this phenomenon exists because people don’t want to face the truth that there is no such thing as a safe investment. They want to live their lives believing that everything will be OK when they retire.
So what does risk actually look like when you’re paying attention?
Risks For Informed Investors
An informed investor knows what most do not:
There is no such thing as a safe investment.
It’s not possible. They don’t exist. Let me first prove it to you by pointing out the sources of risk in some of these so called “safe” investments.
The risks of “safe” investments
One thing that most of these safe investments have in common is that they have lower returns than other types of investing. So they all have risks associated with inflation.
Inflation risk is the risk that the increase in cost of regular purchases will outpace the return of the investment.
Bonds are at the biggest risk for inflation risk, and right now you can’t buy a profitable bond. They also have added risk for a few reasons.
The first is that the interest rate on bonds changes over time. So you may buy a bond today with a 2% interest rate (called coupon rate), but in two years bonds are available with a 5% interest rate. When this happens you either have to sell your original bond at a discount to buy a new bond with the better rate, or you have to accept your poor rate of return.
The second is that bonds don’t offer the power of compound interest. If you put $100 in a bond and have a 2% interest rate, you get paid $2 every year until the bond expires. In investments like the stock market that $2 would also get a 2% return on investment. Not the case with bonds.
So even if you’re technically making money, bonds may actually be losing you buying power. You’ll have more money, but be less wealthy.
Cash or bank deposits
It’s not exactly an investment, but one thing you can do with your money is to hold it in cash or deposit it in a bank.
These uses will normally get you no return at all. If you leave your money in a jar for years, you’ll come back and the money will be there, but it will be the same amount.
We run into the same problem with inflation. Our money is losing value over time and even though we don’t lose money, we’re becoming less wealthy.
I think we can all understand the risk of our cash being stolen, and this is one reason why most people keep their money in a bank. The convenience of bank accounts are great, but keeping your money in a bank presents even more risks.
Just because the total balance of all the banks checking accounts is $1,000,000, it doesn’t mean that the bank actually has $1,000,000 that it’s protecting. Banks invest your money, and they actually go even further. Banks have the ability to create money to give out loans for home purchases and other things.
So there’s a risk that the bank won’t actually have your money when you need it. For the most part, if your bank is FDIC insured, this risk is mitigated. But if banks are investing, then why let them take advantage of your money when you can do it yourself?
CDs and savings accounts
We’re starting to see some trends here. Certificates of deposit and high yield savings accounts suffer many of the same risks as the investments we looked at before.
Their return numbers are not keeping up with inflation. CDs have another problem (shared with bonds as well). They tie up your money. When you put your money in a certificate of deposit, you’re supposed to be trading accessibility of your money for a better interest rate. But interest rates on CDs aren’t much better than the bonds rates of today.
How to use safe investments effectively
Now I’m not saying you should never put your money in a bank account, and I’m not saying that these investments are never useful.
What I am saying is that you need to be aware of where your money is going and what the risks are. I keep enough money in my bank accounts to reasonably cover 2 months of expenses, but no more than that. Banks make it easy to pay utility bills and buy dinner and make other types of purchases. So I keep just enough to do those things.
If you’re saving money to put a down payment on a house, then maybe you could put that money in a high yield savings account while you save. If you put that money in the stock market, it may not be there when it’s time to buy the house.
The risks of “risky” investments
There are a lot of higher return investments that sometimes get labelled as risky.
The stock market is one that many consider a good investment, but it comes with risks that are often disregarded. Real estate is one that is often labelled risky, and certainly has risks, but it those risks can often be mitigated with well thought out planning. Businesses are called risky for their potential to fail, but many of the wealthiest people in the world invest huge amounts of their net worth into businesses.
Let’s look at the sources of risk for these higher yielding investments.
I do like the stock market as an investment, but so many people with retirement accounts don’t fully understand that there are some big risks associated with holding your money in stocks.
The most important one is the risk of your money losing lots of value at inconvenient times.
For example, if you’re using the 4% rule to determine how much money you need to retire, and you reached that number in 2006 or 2007, you may have gone ahead and retired. But in 2008 the value of your portfolio would have dropped nearly 40% in a year or two. That’s a pretty huge risk that actually became reality for a lot of people.
The stock market also has risks associated with timing. If you were investing in the stock market between 1980 and 2000, you would have seen average returns of nearly 20% over those 20 years. Conversely, if you were investing between 2000 and 2020, you would have seen average returns of only 6%. Not exactly exciting.
For regular stock investors with retirement funds or a portfolio full of index funds and exchange-traded funds, your return numbers are often at the mercy of the times. And never forget that you can lose your money in the stock market just as easily as you can with lots of other investments.
Real estate is my main type of investment, so I’ve heard all about the risks of investing in real estate, usually from people who have never done it. The big ones I hear most often are that taking on debt to purchase real estate is a huge risk and that a lawsuit can take everything from you.
These are definitely risks. Not being able to make debt payments can lead you on a path to bankruptcy. And a lawsuit under the right circumstances could do the same.
Those who are most exposed to these risks are investors who aren’t strict enough during their due diligence process and investors who don’t have insurance policies and lease agreements that mitigate the risks of a lawsuit.
Here are some more risks:
- Expensive property repairs
- Bad tenants who don’t pay or cause damage
- Local ordinance changes that affect your business
Real estate investors need to be informed and in the know with their investments. The way I see it, the biggest risk in real estate investing is a lack of planning and knowledge.
You’ll find investors with a wide variety of investment strategies who are consistently successful. The difference is usually not luck, but careful planning and consistent execution.
The purchase process for a business holds many of the same risks as purchasing real estate. You’re often assuming debt, you want to pay the right price, and you should consult a lawyer to make sure you aren’t opening yourself up to unnecessary legal risk.
The operation of the business is different, though.
Most businesses will have employees to manage, pay and insure. They have risks associated with knowledge about the inner workings of the business. What happens when important employees leave?
They may also have risk in the previous owner deciding to compete against the business they just sold to you.
The expenses and revenue funnels of a business can change significantly over time. When supplies have price increases or a contractor increases prices, your profits can really take a hit. And the same goes for revenue streams. Huge businesses like Airbnb and the NBA took huge losses due to various restrictions caused by Coronavirus.
Businesses can be hugely profitable, but they require probably the most knowledge of any investment.
If you didn’t know better, you might think I was trying to talk you out of investing at all! Most of the risks in this article can be either completely eliminated or at least reduced.
My personal opinion is that the investments typically labelled as safe, like bonds and CDs, are actually the riskiest investments today, because it’s impossible to make money from them. I believe that investments like real estate and business are most risky to the uninformed investor. It’s possible to consistently make more money with these higher yielding investments, as long as you do your homework and never skimp on your due diligence.
Mitigate inflation risk
The easiest way to mitigate inflation risk is to avoid the lowest yielding investments like bonds, CDs and high yield savings accounts. Or at the very least you’ll want those to be a small percentage of your investing portfolio.
Since average inflation is around 3%, you’ll want most of your money to go towards investments that do better than 3%.
My personal recommendation is to head to the stock market, or begin investigating real estate or business investments.
Mitigate debt risk
I think there are two main ways to mitigate debt risk. There’s the Dave Ramsey way, which basically says to “don’t ever, for any reason” take on any debt. So just avoid it all together.
I take some issue with this, because we can use debt to significantly increase the speed with which we acquire wealth. I can get 30% returns by using debt, and only 15-20% returns without it.
So how can I use debt while also minimizing the risk associated with it?
My answer is to have a rigorous due diligence process for any investment you’re taking a loan out on.
For real estate this means spending usually 20 hours or more investigating the expenses and expected revenue for a property, as well as going through legal risks. I also try to have a plan B or an exit plan for any real estate investment.
If I’m listing the property on Airbnb, then I want to know how the property would perform as a long term rental as well. And I want to know how easy the building will be to sell if the worst case scenario becomes a reality.
Mitigate legal risk
This one is simple, but so many people just won’t do it. You need to hire the services of a lawyer when you acquire a new investment.
Most investors will never have the expertise and experience to have a good legal plan, so they should pay someone who does. That expense will be far less than the cost of bad legal planning.
Legal risks are extreme. You can literally destroy all the wealth you’ve built up with one misstep, so hire a lawyer.
Mitigate tax risk
Tax risk is serious, but not quite as serious as legal risk. Really the worst that can happen is if you break the law when paying your taxes, which is more of a legal risk.
As long as you don’t break the law, then the worst that can happen is you get hit with a big tax bill at the end of the year and you don’t have enough money available to pay.
This can of course be avoided by putting money aside throughout the year for that purpose.
And hiring a certified accountant is also a good idea. They can keep you informed and often times save you money with good tax planning.
Mitigate timing risk
Some parts of timing risk are unavoidable. If you just happen to be investing at a time when the returns are lower, you can’t exactly time travel to a time with better returns.
But other parts are avoidable.
One way is to refrain from trying to time the market, to basically ignore the timing risk altogether and assume that over time you’ll get hit with big losses but also benefit from big gains.
You can play the long game and just trust that over long periods of time your returns will be favorable.
That kind of sounds like embracing the ignorance, and I guess in some ways it is. I’m sure there are more intelligent ways to avoid timing risk, but I’ll leave those strategies to the stock market experts.
Mitigate holding risk
If you’re already mitigating inflation risk by avoiding low yielding assets like bonds and CDs, then you’re halfway to mitigating holding risk.
But there are plenty of high yielding investments with holding risks. Real estate and business investments carry a lot of the returns in the value of the underlying assets (the property or the business itself). Problem is you can’t exactly sell a house or a business at a moment’s notice.
You have money tied up in those assets and you don’t always get to choose when to pull that money out.
My main strategy for real estate is to use the power of cash out refinancing so you never have to sell. If you own $120,000 of a $150,000 house, you don’t actually have to sell the house to access most of that $120,000. You can have the bank give you an $80,000 loan. Property makes great collateral for a loan, so it’s quite easy to cash out on the equity you have in a property.
The most important thing an investor can do is to become informed about their risks and how to control those risks. There is no one right way to build wealth.
Ultimately, you need to ask yourself what the purpose is for each dollar you earn, and allocate it to the investment that best serves that purpose.
Just understand that no investment is risk free, and it’s up to you to decide which one serves your goals best.