Picking up pennies, in front of a steamroller?

The easy way to explain the risks of some investment strategies is ‘picking up pennies, in front of a steamroller’.

Things where you see comfortable uniform returns, quarter by quarter, or even year by year.

But then one day ‘bang’ all your money is gone – you get steamrolled.

Expats need to carefully select the investments they use. Mini bonds, structured products, alternative fixed income, crowdfunding - often come with hidden risks. Investing in traditional stocks and bonds can be far more transparent.

Investors get lured in, with promises of stable high returns without volatility, often much higher than the stock market offers.

But what they don’t see is while volatility might be not a risk – there is a very real risk of losing all your money.

The business that promised a 15% annual interest payment, suddenly can’t find the money… and you’re left with liquidators trying to carve up assets to repay investors.

Asset class returns are an indication of risk.

Whilst markets aren’t perfectly efficient, on a broad level they price in the risk of different strategies very well.

This can give us a benchmark for what a reasonable return might be (and what might be too good to be true).

Let’s take an example from US Fixed Income markets:

Short-dated Government Bonds – From a default risk perspective, these are considered a risk-free asset. In nominal terms, you will always be paid back.

Investment Grade Corporate Bonds – In short, you should get all your money back plus interest, but it’s not guaranteed.

These are loans to companies expected to perform well by independent ratings agencies, considering their current operations, and the economic outlook.

But as industries and economies change, it’s possible a small percentage of these may default on their debts, and investors could lose their money.

To account for this risk, the additional interest (or spread) paid above government bonds is currently 0.9% – compensation for the higher risk.

High Yield Bonds – High yield investors should expect defaults, so they require even higher compensation for the higher risk.

At the time of writing, credit ratings agency Fitch expects expected 4.0-4.5% of issuers of US high yield debt will default.

In times of economic stress, this number could be far higher. So diversification really matters.

For the extra risk, the spread paid on high yield bonds above investment grade bonds is currently 3.22%.

So if a USD Government Bond pays 3% in interest annually.
A US Investment Grade Bond should pay 3.9%
And a US High-yield Bond should pay 7.12%

As we can see, markets price in risk, by demanding a higher potential return.

Without risk, there are low returns.

If something offers an outsized return, be careful to identify the risks involved, because there certainly will be some…

…Otherwise, they could afford to offer lower returns.

What about “Alternative Fixed Income Investments” offering yields of 10% or more?

I often hear about these sold to investors who are worried about stock market volatility – usually after things have gone wrong.

When it comes to investing, nothing is risk-free (even cash), there are just different flavours of risk – short-term volatility, inflation, and capital loss.

Usually the assumption that something is risk-free, means you just haven’t spotted the real risks yet.

Investments that fall into this Alternative Investment category, with risks that aren’t always transparent, include:

Peer to Peer Lending
Crowdfunding
Speculative Mini-Bonds
Property-Backed Fixed Income Notes
Some Structured Products

If something promises a higher return than the stock market – rationally it also has to be far higher risk than owning stocks.

If something promises those returns without the risk of volatility, there has to be another risk you’re being paid to accept.

Often there is no third party providing a credit rating, to help investors understand the viability of the promised returns, like there is with an investment grade bond traded on a stock exchange.

So many investors don’t see the risks until it’s too late.

The problem with these investments is that the pay-off is defined, but the probability of that pay-off is rarely discussed.

In the stock market, the risks are often clearer.

More traditional investing strategies, like owning great companies for the long-run, can make investing simpler and the risks clearer.

When investing in stocks, the returns are variable, but long-term data can help us understand the probabilities (especially for diversified portfolios).

Let’s take the MSCI World as an example. It contains the 1,500 largest companies in developed markets around the world.

We can look at the returns over 10 year holding periods since 1970, to understand what the probability of success was.

So over 46 different 10 year holding periods, assuming you invested at the start of January in each year and held to 10 years:

There was no 10 year holding period where you lost all your money.
There was 1 period out of 46, where your return after 10 years was negative. A 2.2% chance of a negative return.
There were 7 periods, where annual returns were below 5%.
17 periods saw returns between 5-10% per year.
And 21 periods saw returns over 10% per year.

A 97.8% chance of positive returns, that’s as close to a sure thing as you’ll get.

All investors had to do, was invest in the great companies of the world on day 1, and forget about it for a decade.

Stock markets are volatile, but volatility isn’t a bug, or something to be scared of.

It’s a feature, to be expected. Something that we have to manage through prudent asset allocation, and carefully understanding investment time horizons.

Compared to risk of losing everything in an Alternative Fixed Income Investment, I know what I’d choose – every time.