What is risk?

Jeff raises a great question about the nature of risk; he is talking specifically about real-estate investing when he says:

After reading a couple books, it looks like the majority of the return comes from leveraging your money and keeping your money leveraged over your holding period. Also, reinvesting your cash flows into another investment (instead of living off of them) adds additional compounded return over the long haul. These, however, dramatically increase risk…but, no risk, no reward.

Now, I need to make a point right here: I talk about real-estate (RE) investing a lot … and, I certainly made a lot of money in RE … so, it follows that I am in love with RE, right?

Actually, no.

I hate investing … I dislike real-estate … I abhor risk …

…. it’s just that I hate NOT investing even more. Seriously.

I have a lot of money sitting in the bank earning interest (an excellent rate, if I may say so myself); but all I can think of is that it’s not working fully for me … I am not anywhere near maximizing my return. Where’s the capital gains?

In the bank, there is none.

So, I am FORCED to look elsewhere to invest, and I inevitably end up back at real-estate. I do it because, for me, it represents the best risk/reward trade-off that I can find … IF I am certain that I can cover the cash flows if things go south for a while (repairs and maintenance, loss of tenancy, etc.).

Jeff is absolutely right about RE’s ability to get returns ” from leveraging your money and keeping your money leveraged over your holding period”.

But, back to Jeff’s questions about risk: when Jeff says that leverage = risk, he is technically correct but absolutely incorrect.

Let’s take a look at the technical nature of risk:

Case 1 – RE v CD

We compare the risk of investing our $100k into a $100k piece of real-estate (no borrowings, and for the sake of the discussion no closing costs) v. into a bank CD and we realize that the piece of real-estate and CD produce differing rates of return: according to common wisdom, slightly above inflation for the RE and about even with inflation for the CD.

But, the RE can burn down, lose a tenant, etc. etc. Of course, on the plus side, you can rehab the property cheaply and increase returns; choose better tenants; find a high-growth area; etc.

The CD is fully government-insured (hence the $100k limit for this exercise); and, you can look around for the best CD deal (from an insured bank!) in town.

Bottom line: Slightly different rates of return, markedly different risks.

Intuitively, we understand that there is a relationship between risk and return and the RE v CD example illustrates that in a way that we can all understand.

Case 2 – RE v RE

Let’s say that you decide that the better return from RE is worth the increased ‘risk’.

RE can be leveraged; so that must increase risk? Again, technically ‘yes’, but let’s look at it in practice:

0% leveraged RE v 100% leveraged RE:

If the ‘sub-prime crisis’ didn’t show the risk (not necessarily the folly) of ‘no money down’ RE deals, then we may as well stop the discussion right here, because we all know that fully-leveraging a property is much more risky than owning it outright (it’s why we pay down our home loans, right?)

But what about 0% leveraged RE v just 20% leveraged RE?

Does that seem a lot more risky to you? If not, what about 0% leverage v 40% leverage … and so on.

In other words, risk is also personal: once you decide to invest in an asset class – say, RE – there is no magical point at which leverage becomes ‘risky’ or ‘not risky’ (unless you were one of the people who thought that 20% leverage was ‘risky’).

The point here is to show that whilst there is indeed technical risk, it can be highly subjective and frankly far less important to your financial decision making than ‘absolute risk’ …

Absolute Risk

To put this in perspective, we all know that trying to jump over roofs between buildings is risky. Much more ‘technically’ risky than going through the fire doors, down the fire-stairs, into the street, then reversing these steps in the next building …

… but, if you are Jason Bourne and a CIA Operative is coming through the doorway behind you with a BIG GUN (did I mention that you were out of bullets?) to ‘take you out’, don’t you think that you just might suddenly ignore the ‘technical risk’ and jump across anyway (if you thought there was any reasonable chance that you might make it)?

Instead you might decide to try and surprise the armed assailant with a karate chop (what is the ‘technical risk’ of karate chop v armed assailant?) … in other words, you mostly ignore ‘technical risk’ because the ‘absolute risk’ of failure is too great.

Equally, financially-speaking, ‘absolute risk’ is the only risk that really matters; it simply asks:

What is the risk that [insert preferred method of investing here] won’t be enough for me to make my financial goals i.e. my Number /Date?

If putting your money in a bank CD that earns 4.5% gets you to your financial goals, then that’s probably what you will/should do.

But, if it won’t what do you do?

It all depends on how important your financial goal really is, doesn’t it?

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12 thoughts on “What is risk?

  1. Good point, Adrian.

    I sometimes think we need to have our backs to the wall to do the things we otherwise won’t do. How many people have we heard about say that losing their job was the best thing that happened to them? How many of us are willing to find out if they are right, tho?

    We worry about the dark mark on our employment history should we end up going hat-in-hand to another place, the effect on our morale (and subsequent effect on negotiating), as well as the effect on our credit rating if we do something else that could really screw that up as well (what if I extend myself farther than I am able to recover, and my credit rating plummets or I have to file bankruptcy – what then?)

    Sometimes necessity is the mother of invention, rather than laziness.

  2. @ Diane – Let’s hope that we don’t HAVE to make that choice to ‘jump between roof tops’ … but, it does illustrate the smaller decisions – and risks – that we MAY need to take in order to reach our financial goals.

    For example, does your financial goal require you to ‘jump between roof tops’ (or, at least take some greater risk than perhaps paying down your mortgage or investing in a CD may provide)?

    If you answered ‘YES’, is your financial goal worth the risk?

    If you again answered ‘YES’ you know what you need to do 😉

  3. If we are talking about reaching our Number by our Date, we can only choose the investments(and their inherent risks) that can get us there. Plan and simple. Nothing less will work unless we open ourselves to settling for less(which will make getting less/later MUCH more likely).

    So if you have a BIG number at a SOON date, you are probably going to have to leverage and take the relative risk, but reap the reward in the end. If you are even smarter, you’ll continue to find ways to cut the ‘risk’ on the relative ‘risky’ investments even further and if you fall down, you still get back up and do it again until you get there! Good post.

  4. I think this is part of the challenge for me . . . I have a clearer notion of “acceptable risk” than of “number” or “date”.

    So maybe I need a different approach: Instead of defining number and date and determining risk, maybe I should be defining risk and number and determining date from that. In my situation, the date isn’t key; I’d rather be reasonably sure of getting there and risk getting there ten years late, than risk everything and not get there at all.

    Maybe it’s not, “Pick number and date, then determine risk”, but “Define the two most important: Number, date, or risk. Then guess what the third variable will be, given the other two, to see if it is acceptable. If not, you need a smaller number, later date, and/or higher risk.”

    Of course, I’m not the millionaire here . . . these are just my thoughts looking on from the goal setting stage. I like to think “out loud” 🙂

  5. It seems to me everyone has their own risk tolerance. Using RE for example, as one increased the percentage of leverage in a property from 20% to 30% to 40% etc…the risk may become to great at say 60%, then 60% is your risk tolerance (at this point in time).
    I also believe risk tolerance is directly proportional to the effort needed to recover from a complete loss in a leveraged position (meaning you actually end up in debt if the investment fails). At this point in time, claiming bankruptcy from a failed investment is beyond where my pain/risk tolerance level is at.
    Do you think I can still achieve 170% return with this risk tolerance Adrian?

  6. The problem with getting to the number is indeed risk as AJC has pointed out. But what is risk? Defined by mathmaticians it is variability. With a CD you have a fixed rate of return so little risk/variability UNTIL your CD contract is finished and you have to sign up for another one. You might find yourself in a market with a significantly lower set of CD rates at this time and that indeed is risk/variability. The mutual fund sales people have pointed out that the longer time horizons decrease risk as returns “return to the mean” (sorry another math concept!) which means an increase liklihood to get the historical average return for that asset class. So the longer your time horizon the lower your risk/variability!

    This is where real estate shines! Because it is not liquid (meaning it is harder to sell) and there are significant transaction costs it forces folks to stay for longer periods of time, therefore reducing risk! The key of course is to set up real estate with cash flow (and have reserves) so there is not a time you are forced to sell.
    By doing this you minimize the risk of leverage.

    So by owning investment real estate for relatively long period of times you reduce the risk/variability of capital appreciation, and can use leverage to triple or more the appreciation, while having an increasing stream of cash flow.

    The alternative is to take on more risk/variability of the more liquid investments.

  7. @ Jeff – I also said that you were ‘correct’ 🙂 And, we are indeed talking about two different things … and, it was your original comment that inspired this post, so thanks!

    @ Scott – Well said; of course, there is a third choice: allow yourself to fall short of your goal because of fear … because of fear, lots of ‘Jason Bournes’ choose Door # 3: getting shot even when the ‘jump’ is well within their abilities.

    @ Ethel – just rework until you have a Number that is your minimum acceptable and a Date that is maximum acceptable. Then choose the lowest risk investment (that is within your ‘comfort zone’) that gets you there … without both Date AND Time, most will say that you have no goal, just a vague direction. If having no goal is acceptable, then any road will get you there, so choose the easiest one!

    @ Josh – Bankruptcy is the financial equivalent of Jason Bourne not quite making the jump, hanging by his fingernails and eventually falling … of course, bankruptcy conveniently puts a stuntman’s net at the bottom 😉 And, yes, you can start a business and get super high returns without risking bankruptcy in the process … it’s the 170% you should be concerned about, though, not the 0% that you are worried about.

    @ Shafer – Actually, starting a small business outshines RE … but, the risk of failure is higher; there are plenty of investments other than RE that have made people rich reasonably safely (just ask Warren Buffett), but your point about RE is taken 🙂

  8. Yes AJC you are correct; starting a buisness is a great way to produce wealth and also risky. That’s why I suggest doing both; becoming an active investor and starting a business on the side at first. Matters little what investment class as long as you become an expert at it. Real estate just allows you to reduce risk.

  9. @ ShaferFinancial – Risk is in the eye of the beholder 🙂 But, if a bank is willing to put up 80% or more of the purchase price of a property, I would have to agree, that is low risk!

  10. @AJC – Is that what the date is supposed to be, the maximum amount of time to get there? That’s a clearer way of stating it, I think, that what was said before, because I have always been a bit foggy about the date – 5, 10, 20 – such even (in 5s) numbers…

    @ Scott, thanks for the encouragement and reminder about the get-right-back-up-and-get-back-in-the-fight. Definitely so true. It’s like the driver in one of those comedy racing-cars-across-the-USA movies back in the 70s. The Italian driver tore off his rearview mirrors and state, “What’s behind me does not matter!” (and that includes that 0% (or less!) ROI. It just gives us another baseline to keep pushing off from.

  11. @ Diane – the Date is when Life After Work begins (and, you had better have a sh*tload of passive investments throwing off enough cash to keep you living in the style to which you will no doubt become accustomed).

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