Investing involves prudent risk-taking. Identifying and managing risk should be a core responsibility of every Investor/Fund. There are basically three (3) types of risk management strategies available. These are:
Asset Allocation - Diversification of Portfolio;
A. Asset Allocation - Diversification of Portfolio
By far the most employed and recommended Risk Management Strategy offered by Investment Advisors. This strategy involves spreading the investment amount to at least six (6) asset classes which typically include:
1. Developed Market Equities;
2. Emerging Market Equities;
3. Treasuries and Cash;
4. Inflation-linked Bonds;
5. Private Equity;
6. Real Estate.
The range of yields from these asset classes can range anywhere 3% - 30% with the risk level managed through the amount of investment that is placed in each asset class. Low risk tolerance investors allocate larger amounts in the more risk adverse asset class whereas high risk tolerance investors allocate larger amounts in the less risk adverse asset class.
This type of strategy which can realistically be termed “Financial Darwinism ‘ Survival of the fittest” while often recommended has the two (2) fatal flaws of all correlated risk management strategies, Geopolitical Market Risk that can effect the entire Financial Market as well as Target Company and/or Product Risk, Additionally this strategy represents a huge opportunity cost for those low risk tolerance investors. All of these concerns are further magnified by the payment of fees which vary from asset class to asset class and in some cases can be significant, thereby reducing the overall yield.
U.S. Treasuries like U.S. T-bills, Notes and Bonds are widely considered the safest investments in the world and are often employed in risk mitigation/risk management strategies. Treasuries are backed by “the full faith and credit” of the U.S. government and, as a result, the risk of default on these fixed income securities is next to nothing.
Not even the safest corporate bond in the world can make that claim. When you buy a Treasury Bill, Bond or Note, you can rest assured your principal will be returned in a timely manner along with all the interest that’s due. But the fact that your principal investment is protected does not mean that Treasuries are completely risk-free. In fact, holding Treasuries poses some very specific risks like inflation risk, interest rate risk and opportunity cost.
a. Inflation Risk
If inflation rises, the value of your Treasuries investment may decline. Consider for example that you own a Treasury Bond that pays interest of 3.3%. If the rate of inflation rises to 4%, your investment is not “keeping up with inflation” and as such the real value of the money you invested in the Treasury Bond is declining. Although you’ll get your principal back when the Bond matures, it will be worth less.
b. Interest Rate Risk
If you hold the security until maturity, interest rate risk is not a factor. You’ll get back the entire principal upon maturity, but if you sell your Treasury before maturity, you may not get back the principal you paid for it.
If you bought a 4% Treasury Note two years ago and now because interest rates have generally risen, a similar Treasury Note pays 5% interest, your 4% Treasury Note will send at a discount and likely won’t return all of the principal originally paid. The Note will be discounted until the current yield equals the 5% interest paid on similar Treasuries being issued now. Depending on the interest rate difference, this can result in a substantial principal loss.
c. Opportunity Cost
Treasuries are so safe that they don’t have to pay interest to attract investors. As a result, the yields on Treasuries often fall short of the yields on even very safe investment grade or better corporate debt. That doesn’t cost you money, but it could cost you the opportunity for a higher return on another investment.
This is the opportunity cost, the difference between what you earn on an investment and what you could have earned if you had invested in something else. This is one of the biggest risks for Treasury investors that in being too afraid of risk, they’ve invested too heavily in low interest - rate treasuries.
C. Stock Options
Options strategies are basically bets against the market and time. They seek to use the power of leverage. Unfortunately, if time runs out and an option expires worthless, it’s a bad investment and a terrible risk management/risk mitigation strategy. It may not have been a bad hedge, a bad bet, or a bad speculation - but it is a bad risk management/risk mitigation technique.
In fact, roughly 80% of all options expire worthless. It is why options have so much risk. Even the underlying security of the option is at risk when you write an option on it. Investors using options cannot sell the security until the option is covered or expires. During that time period you could lose money. All in all though if Stock Options are recommended as a Risk Management Strategy, it is clearly the worst choice available.
Bach Capital Management is a truly independent consulting firm that you can trust in providing the proper risk management strategy to meet your needs and your circumstances. We bring the full spectrum of financial and business experience into our business consulting l advice that is focused on your goals.
As the saying goes, “when you’re a hammer, everything looks like a nail.” This is unfortunately how we see both the consulting and financial industry as a whole. These industries push product as opposed to honest consulting. This is why we are independent consultants and why we love what we do so much. This is fun for us. With over 40+ years of business and financial services experience, we think you will be impressed with how we can help your business reach and perhaps exceed your goals.
Contact us and let’s get started.