We often see debates about whether or not volatility of returns is a good measure of risk.  This debate is related to what I think is a bigger issue: the difference between perceived risk and actual risk.  Perceived risk is influenced by observations and “dollar bias,” but actual risk comes from the full range of what might happen and its influence on buying power. Dollar bias and buying power In some contexts we forget about inflation and view dollars as constant over time.  For example, we tend to focus on nominal returns and think that it’s okay to spend gains as long as we leave the principal intact.  But the principal will erode with inflation if we spend all the nominal gains. Another context where we see this bias is with mortgages.  We can calculate that with a 30-year $400,000 mortgage at 4%, the first year’s payments will only reduce the principal by about $7000.  But even with only 2% inflation, the buying power of the principal will erode by abo...

When it comes to finances, the definition of “risk” is tough to pin down. We sometimes refer to portfolio volatility as risk, but this doesn’t line up well with what people mean when they talk about stocks or other assets being risky. William J. Bernstein brings us some clear thinking about risk in his 55-page book Deep Risk: How History Informs Portfolio Design , the third of four books in his Investing for Adults series. Bernstein thinks of risk “in two flavors: ‘shallow risk,’ a loss of real capital that recovers relatively quickly, say within several years; and ‘deep risk,’ a permanent loss of real capital.” “Capital managed for near-term liabilities should be guided by shallow risk, while capital managed for very long-term liabilities should be guided by deep risk.” This book “provides a framework for thinking about deep and shallow risk as essentially an insurance problem involving probabilities, consequences, and insurance costs.” “The conventional ‘shallow’ risk of st...

Last week’s article on Smith Manoeuvre risk sparked reader RS to ask the following thoughtful (lightly-edited) question: Have a mortgage and have non-registered investments (mostly in XIC) that can cover a significant portion of my outstanding mortgage. Wondering if it will make sense to pay off the mortgage using non-registered investments and take a HELOC and buy the same (or similar to avoid attribution) assets. I will be in the same position as I am now, but now I will be able to write off interest (which will be about 25% more in HELOC). My marginal rate is 50%, so I guess it might be advantageous. I will also need to factor in any capital gains taxes (25% of gains) that I will incur now against the savings. But this thinking sounds too simplistic. Not sure if I am missing something here. I don’t think you’re missing much. Given that you have had a mortgage at the same time as building non-registered investments, it would have been better to have set things up to make your...

Yet another survey concludes that people are pretty dull when it comes to finances. This time it’s the Teachers Insurance and Annuity Association (TIAA) Institute who asked just over a thousand Americans 28 financial questions. The respondents didn’t do very well. But sometimes, it’s the designers of the study who are dull. A Wall Street Journal article quotes one of the survey’s 28 questions: There’s a 50/50 chance that Malik’s car will need engine repairs within the next six months which would cost $1,000. At the same time, there is a 10% chance that he will need to replace the air conditioning unit in his house, which would cost $4,000. Which poses the greater financial risk for Malik? Anyone mathematically inclined sees instantly that the expected cost is $500 for the engine and $400 for the air conditioner. But the question is which potential repair “poses the greater financial risk for Malik?” In the field of assessing threats and vulnerabilities, “risk” is defined ...

I frequently see people whose financial plans rest on a steady income. I’m not just talking about those living hand-to-mouth, never saving a dime. There are also the “spreadsheet planners” who have their financial lives all mapped out. They borrow large sums for a house or to invest, and rely on a steady income to keep up with the interest payments. As long as everything proceeds exactly as they planned, they’ll be multi-millionaires by the time they get close to retirement age. I’d like to introduce these people to Heather Von St. James. Heather had a great life going but was hit with mesothelioma, a cancer caused by asbestos. Her story about the personal and financial costs she faced is definitely worth a read. ( Disclaimer: I have no financial connection to Heather; I just found her story compelling. ) One takeaway from her story is that your income is not fully secure no matter how safe it seems. Heather’s story is a very specific case, but there are many different pro...

A very thoughtful post over at How to Invest Online looked at the opinions of various investment theory heavyweights on the question of whether owning an index of stocks becomes more or less risky the longer you hold them. I want to address the argument that because “the spread of possible ending dollar values get wider, not narrower, with time,” stocks keep getting more risky over time. At its core, this argument is playing a semantic game with the word “risk”. To explain what I mean, imagine you have the chance to invest in the following hypothetical investment: 1or2 investment : Each month you toss a fair coin. If it comes up tails, you get a return of inflation+1%. If it comes up heads, the return is inflation+2%. This looks like a fantastic investment. After one year, you’ll beat inflation by between 12.7% and 26.8%. Even the worst-case scenario gives a better return than most of us could possibly hope for. The 1or2 investment is risk-free in the every-day sense of ...

During the 2008/2009 stock market crash, it wasn’t too hard to find people telling you to re-evaluate your asset allocation and tolerance for risk . However, that was a terrible time to lower you portfolio risk; now is a much better time to consider this question. It’s natural for your emotions to tell you to sell stocks after they’ve dropped and to buy more after stock prices rise. To a certain extent it is these emotions that drive stock market swings. However, it’s not too hard to see that this behaviour amounts to selling low and buying high, which is exactly the opposite of what most investors want. Re-evaluating your asset allocation isn’t necessarily a bad idea, but there are wrong times to do it. The stock market lows of March 2009 were the wrong time to consider selling stocks. Even if you were right in deciding that your stock allocation was too high for your risk tolerance, making a change back then would have caused a permanent loss of capital. Now would be a gre...

Imagine what life would be like if you saw all amounts of money in terms of constant year 2000 dollars. Because there has been about 28% inflation since the year 2000, if your friend saw a jacket on sale for $128, you’d see the price as $100. While other people would see prices rising over time, you’d see the average prices of the things you buy stay roughly the same. Any cash that you keep hidden in your sock drawer would shrink slowly over time in your eyes. This change in your perception would have a number of interesting effects including your perception of investment risk. While most people would see their pay stay constant for the year and then step up at raise time, you’d see your pay cheque drop by a little each pay period. At raise time your pay would go up, but not necessarily back to what it was at the start of the year depending on whether your raise exceeded inflation. If you had a $10,000 emergency fund in a regular savings account that pays 1% interest (which is...

Most of us have heard that it is good to hold asset classes with low or negative correlation. The informal explanation for this is that risk is lower because when one asset class, such as stocks, is going down, another asset class, such as bonds, is going up. However, this explanation is misleading. It is possible for two investments to both be going up over a period of time, but have negative correlation. Consider the following example: Investment A earns either 2% or 20% each year based on a 50/50 coin toss. Investments B, C, and D do the same. Investment B's return is based on the same coin as A uses. Investment C uses its own independent coin. Investment D does the opposite of A's coin. All 4 investments have an expected compound return of 10.63% (for math geeks, this is 1 less than the square root of 1.02 x 1.20). Even though the investments all look the same based on their returns, their correlations are different: A and B are +100% correlated (perfect cor...

Taking into account the nature of your employment when constructing your investment portfolio makes sense. Stock brokers may not want to expose their portfolios to too much stock market risk because their wages depend on the stock market performing well. However, paying too much attention to risk at the expense of expected returns can lead to problems. In his book, Your Money Milestones , Moshe Milevsky quotes a study saying that MBA students interested in a Wall Street career should consider shorting the stock market upon entering school. This is a good example of focusing on risk at the expense of expected returns. It is definitely true that these MBA students are exposed to stock market risk. If the markets perform poorly while they study, their job prospects upon graduating may be grim. Shorting the stock market would yield profits in this case and reduce their overall financial risk. However, stocks have a built-in tendency to go up. We may disagree on how large the r...

Researchers have found a link between attitudes towards long shot financial risks and a specific gene. We tend to like paying a small price for a long shot at a big gain such as in a lottery. At the same time, we tend to prefer paying a small price to avoid taking a chance on a big loss, which explains insurance. The researchers found that how much we like going for big gains and avoiding big losses is linked to a gene called monoamine oxidase A (MAOA). It turns out that those with a more active version of this gene are more likely to enjoy lotteries and less likely to want insurance than those with the less active version of the gene. To overstate the results, we have two kinds of people: 1. Long shot gamblers who aren’t worried that their houses will burn down. 2. Non-gamblers who buy the $75 extended warranty on a $300 television. An interesting question is whether many people are able to overcome their perceptions and emotions to make rational decisions. I see this as ...

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy. In a previous post, I showed how the average real return in the U.S. stock market from 1926 to 2000 is 9.3%, but that this translated into a compounded real return of only 7.4% . The reason for this difference is the volatility of the returns. Let’s go for a better understanding of the cost of volatility without any advanced math. A Simple Example Suppose that you have $10,000 invested for two years. In the first year you lose 10%, and the next year you make 10%. It might seem at first that you have your $10,000 back, but that isn’t exactly right. After the first year you were down to $9000, and then in the second year you earned 10% on that $9000 to get a total of $9900. In the end you lost 1% of your money. However, the annual returns were -10% and +10% for an average return of 0%. The lost 1% over the two years is not due to a negative e...

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy. How you ever been to see a doctor who is obviously upset about something that has nothing to do with you? This has happened to me a couple of times where a doctor was complaining about something and I had little choice but to sympathize even though I was much more concerned about my own problems. Otherwise, why would I be seeing a doctor? One of these times the doctor was having a problem with her extended health coverage for topping up the basic government medical coverage. Her partners wanted her to go in with them on a plan that cost $400 per month for each doctor, but she saw in the fine print that the plan had a lifetime cap on all benefits of $25,000. She correctly figured out that she would pay $25,000 in premiums in just a little over 5 years. I asked her if she could afford to pay $25,000 right now if she had some sort of medical problem, and ...

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy. Some financial decisions, particularly about insurance, must take into account what is called the utility of money to get the right answer. Normally the concept of utility is explained in very mathematical terms, but it doesn’t have to be. Let’s take a fun example straight from a game show. You’re standing beside Howie Mandel playing a super-sized version of Deal or No Deal. You’re down to just two amounts left, 1 cent and $3,000,000! You get the following offer: take $1,000,000 now, or take a 50/50 chance at the $3,000,000. What should you do? If you got to do this many times, then on average, taking the chance you would win half the time and get an average return of $1,500,000. This is more than the million dollars you were offered, and so you should take the chance, right? Not so fast. Most people would correctly figure out that they should just...

Much of economic theory is built on the assumption that financial returns follow the well-known Bell curve. However, there is much evidence to support the idea that the Bell curve understates the likelihood of extreme events. Some theorists believe that financial returns follow a Cauchy distribution, which is superficially similar to the Bell curve: However, the Cauchy distribution is narrower in the middle and higher at the sides. This means that mild events are a little less likely and extreme events are more likely. To see just how different these curves are for extreme events we need to look at the same curves on a log plot where each horizontal gridline represents a factor of 10: A 5-standard deviation event on the Bell curve is very unlikely, but the same event on this Cauchy distribution is about 6000 times more likely. So, if a financial institution was selling insurance against unlikely events based on the Bell curve, it might charge a million dollars, but really have a 6-bi...

“When most people are faced with making important decisions in the face of ... uncertainty, their gut reaction is to consult with experts ... even though [they] know that it’s impossible to foresee what the future will bring.” – Curtis M. Faith in Inside the Mind of the Turtles: How the World’s Best Traders Master Risk . Television shows are filled with experts predicting whether stocks, interest rates, and currencies will go up or down. The truth is that these people are just guessing. The odds may favour a given stock going up instead of down, but either outcome is possible. If we are betting on the outcome of a coin toss, no amount of consulting experts will allow you to determine whether it will come up heads or tails. However, for some reason we tend to seek and listen to experts who express opinions confidently about outcomes that, in reality, could go either way. A related human quirk is the tendency to seek the perfect course of action in the face of uncertainty. Committees...

The book Inside the Mind of the Turtles: How the World’s Best Traders Master Risk , by Curtis M. Faith is primarily about ways to both embrace risk and protect yourself from risk. The publisher, McGraw Hill, has graciously offered two giveaway copies for my readers. To enter the draw, send an email with the subject “Book” to the address shown on the upper right corner of this blog. The draw will close Sunday June 14 at noon. I will contact the winners to get (Canadian or American) postal addresses. Curtis Faith offers 7 rules for dealing with risk: 1. Overcome Fear. Fear clouds judgment. 2. Remain Flexible. Surprise outcomes may require a change of plan. 3. Take reasoned risks. Risk can be good if the odds are in your favour. 4. Prepare to be wrong. Plan in advance how to deal with unfavourable outcomes. 5. Actively seek reality. See the world as it is rather than as you want it to be. 6. Respond quickly to change. If your plan calls for some action in the face of unfavour...

Recent stock market declines forced Manulife Financial to borrow $3 billion from the Canadian banks. This brings to mind one of the risks of buying any type of annuity including IncomePlus: default by the insurance company. The main drawback of IncomePlus is the high fees and the likelihood of not keeping up with inflation . On the positive side is the protection from a prolonged decline in stock prices. If stocks perform poorly for a long time, customers of IncomePlus will get a steady income eroded by inflation, but at least it wouldn’t drop in absolute terms. But if this doomsday scenario for stocks plays out, all IncomePlus customers will be leaning on the insurance guarantee all at once. What happens if Manulife runs out of money? Existing regulations require Manulife and other insurance companies to maintain certain financial reserves, and this was the reason for the $3 billion loan. If stock prices really do decline for a long time, creditors will eventually stop lend...

I stumbled across an excellent radio program (no longer online) where we hear from borrowers who didn’t have to show any credit worthiness, a broker who aggressively sought out borrowers without caring whether they could pay back loans, and other players up the food chain packaging mortgages into investments for the $70 trillion world-wide fixed income market that hungered for higher returns than US treasuries. Over the course of many steps, a half-million dollar loan to someone with low income was merged with other bad loans and transformed into an AAA-rated investment. This story is part stupidity and part greed. Unfortunately, both parts are extremely large. With stories like this it's easy to get discouraged. Are we all just greedy idiots? On the other hand, we still have too much food to go around and far more clothing for sale than we could possibly wear out. Life is pretty good whether we’re greedy idiots or not. For most of us, unhappiness is driven by envy of our...

Unlike most investing products, life annuities actually solve a problem that do-it-yourself investors have difficulty handling on their own: longevity risk. By controlling my own investments with low-cost index ETFs, I can beat most professionally-managed mutual funds. However, when it comes to my retirement years, it will be hard to decide how much money it’s safe to spend because I don’t know how long I’ll live. If you control your own investments, the only practical approach in your retirement years is to spend little enough that your money will last to the end of a very long life. Just because the odds are only, say, 50% that you’ll make it to age 80, that doesn’t mean that you can get away with saving only half a year’s worth of spending money for your eighty-first year. If you make it to age 80, you’ll need a whole year’s worth of money. Life annuities are an insurance product designed to solve this problem. The insurance company takes a lump sum of money from you and pa...