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Risk; Let’s talk about risk a misunderstood concept September 29, 2008

Posted by shaferfinancial in Uncategorized.
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This week is risk week at Uncommon Financial Wisdom.  I will post all week on risk, what it is, what it isn’t, how to manage it.  But first let’s talk about what risk is!

I divide investment risk into four areas, strategic risk, systemic risk, emotional risk, and longevity risk.  Today we will talk about strategic risk.

Strategic risk is a variable that often gets left out of the discussion. It is the risk that your strategy will not give you the needed returns to reach your goal.

It easiest to understand by using specific examples. Let us begin by saying you have built a wealth plan that requires you to get a 10% rate of return from your investments in order to reach your goals. Now you look at the world of investments and you note that the stock market has returned 10% since WWII, real estate has returned 6%, and bonds 6%. So you figure equities is where you want to be.  However, what are the chances you can get this rate of return?  That is the risk.  Since, you can’t buy the whole stock market you settle for a broad based indexed mutual fund.  However, all mutual funds have expenses.  Now we know that the average mutual fund has returned around 7.5% over the last 35 years. Not bad, but we can’t find a single mutual fund that has returned that high over that long of time period, and certainly we can’t find one that has returned 10%.  So that forces us to trade mutual funds searching for funds that are doing well while our existing one is not in order to try to pump up the return.  But research has shown that active trading, on average, lowers our rate of return.  So for this investment we see there is a large amount of strategic risk.

Lets look at real estate. On the face of it a 6% return will not get us anywhere close to our 10% requirement. But, we can safely use leverage with real estate. Lets say we purchase our re investment with a 80% Loan to Value mortgage, so we are leveraged 4 to 1. Now there are huge swaths of the country where putting 20% down will give you a positive cash flow, but lets be conservative and say our expenses equal our costs for this real estate.  For the time being lets not count our depreciation, real estate taxes, and mortgage interest, tax savings.  And lets say we allow our loan to value to go to 50% before we put that equity to use again so we have a two to one average leverage over the long run.  With a two to one leverage situation for every 1% appreciation we get 3% rate of return.  So if over the long run we get the historic average (6%) our rate of return will actually be 18%; well more than we need to reach our goal.  Now what is the strategic risk with real estate? If the long term real estate return is only 4% (33% less than the historic average) we still make our goal with some to spare.  Would we say that our strategic risk is exponentially less than with mutual funds? I would!  Comparing odds, what are you chances of getting 25% more than the historic average for mutual funds compared with getting 33% less than the historic average with real estate? And remember we set aside the tax advantages for real estate, and did not count any positive cash flow that would likely accumulate!

Here is another quick example. The historic average over the last 40 years of an average mutual fund (can’t really find a mutual fund that has been around that long with the same money manager) is 7.5%.  The historic average for Berkshire Hathaway over that same time period is 21%.  What are the odds of that Berkshire Hathaway going forward produces returns 1/3 as high as its 43 year history?

Note that financial planners never talk about the strategic risk of any given investment. Nor do they build plans that give you any idea of what the needed rate of return will be to obtain goals. Now you know why.

 

Let’s me teach you how to build the bridge to your goals instead of that bridge to nowhere!

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