The Game of Risk

Recently, while looking through some analysis on Risk, I found a pyramid identifying the general risk associated with each asset class.There are a few things I found interesting. Firstly, is the fact that the chart may not have any true validity to begin with.

What is Risk?
I define risk as “a reality which reaches further than a perception”. In other words if I like Skydiving and I take courses on the art, learning everything there is to know about it, and following that I sign my life away knowing that at any moment something can and may go awfully wrong, then this is not a true risk. On the other hand if a perfectly sane man walks into what he considers a perfectly strong building, but fails to realize that the floor has no steady support, that my friend is risky.

When is Risk?
Ben Graham in his book The Intelligent Investor makes it quite clear that although stocks carry a much higher overall profit potential they may not always be considered risky, and while bonds and cash may hand over consistent returns they may not always be considered as safe.

It would seem that in the late 1970s, cash and cash equivalents, as well as bonds were the place other than where any investor would rather be. Inflation had been killing the dollar and even with the 30-Year Treasuries selling with a 13% annual return bond investors remained uninterested (pun intended). However, looking back, that opportunity could have made any risk-savvy investor wealthy beyond his dreams. The individual who bought those bonds, maturing in 2012, would be walking out with returns of over 20% including price adjustments – risk-free. He wouldn’t even have to properly time the market as to when to get out as would be necessary with stocks.

Stocks too sold at silly bargains. Disney’s shares were selling for less than its book value. Major corporations were selling at prices only single digits times earnings, with numbers that would make Ben Graham smile.

Today however we see quite the opposite. It seems that most investors opt to wager their life savings (this goes out to all those who configure 401ks into the Negative Savings Rate) with much riskier vehicles such as futures and options. As a matter of fact Americans have come up with even stupider ways to throw out their money, i.e. personal Hedge Funds and leveraged Real Estate bought with ARMs, not to mention rare art collectibles, private equity and emerging markets.

Let us remember that as safe as many investors consider options you still have to know what you are doing. Yes you can gain a lot more than you can lose but let us not forget how much you can lose… everything! So that would make options safer than futures where you can lose more than you put in, but one can also take on more leverage.

Aesop said “After all is said and done, more is said than done”. In the wacky world we live in today I would have to say that it may not always be true. At least in the financial markets. It seems that in an age when speculators now call themselves investors, options are considered ample insurance and bigger returns are all that matter, risk as it is has long been forgotten.

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