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?
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’ …
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?