In a couple of my posts about Skin in the Game, I referenced the importance of differentiating between contagious risk and independent risk. Today, I wanted to look at a similar idea – recurring risk – because I feel it represents one of the most significant themes in the book.
Let’s start with a common piece of investment wisdom that I’ve passed along myself once or twice around these parts – the magical index fund. The basic theory is simple – an investor who buys an index fund will earn matching returns to the market. And since the market tends to generate positive returns over time, such an investor is almost sure to do well over a long period. In fact, if the investment is made over several decades, the index fund basically ensures the best possible balance of low risk and high return.
Sounds good, right? There is a catch, of course, and this is where recurring risk comes in. If an investor remains in the market for a long enough time, there will eventually be a rough period or two. The only way an investor will not earn a matching return to the market is if these losses force a reduction in market position. This might not sound like such a problem at the time the investment is made and it is easy to resolve austerity in the future (if times get tough, I’ll tighten the belt elsewhere without touching the investment) but this stance overlooks the strong likelihood that tough times will go hand-in-hand with a declining market. It’s hard enough to invest money during a good economy – when the economy slows down (or even goes into a recession) it becomes even harder to justify putting money aside when it might be needed for more urgent short term purchases.
An investment survives if the investor limits exposure to risk so that losses do not lead to a reduction in position. Therefore, the longer the time horizon for the investment, the more important it is to consider exposure to risk. Otherwise, the investment is sure to give way at some point to a short-term cash need resulting from one of the many ‘unexpected’ personal finance crises that emerge over the course of several decades. To put it in more general terms, survival means being able to hold a position in the face of volatility.
The math behind this line of thinking suggests that in terms of probabilities the relationship between risk, volatility, and time are roughly equivalent. An investment with a small risk of major losses – let’s say 1% – likely generates a small positive return most of the time. However, since investors generally hold their positions in the case of any small positive return, then this strategy is the equivalent of saying – I won’t make a decision about my position until I suffer a major loss. How confident are you going to be in your position if the most recent event was the biggest financial loss of your life? Put this together with the likelihood that these losses tend to coincide with economic downturns, slowdowns, or crashes (and all the short term financial pressure these events create) and you can begin to see why it is far more difficult than advertised to earn a matching return to the market.
When an investor is unable to hold a position no matter what, then in a probabilistic sense the strategy over time is roughly equivalent to being a guaranteed failure. In layman terms, this is like walking into a casino, betting it all on red, and resolving to continue putting all your winnings on red until you are wiped out. It might not happen right away, but no matter how you spin it it’s only a matter of time.
