A Tale of Risk and Reward

Let me tell you story.

There was a man who considered himself to be a very conservative investor.  He said he could not handle any losses in his accounts.  He asked his newly acquired financial advisor to take a look at his 401(k) account, to which he had been contributing for over 20 years.  His employer used a major 401(k) provider, who offered hundreds of fund choices with the plan.

His financial advisor took a look.  And was shocked.  And well, was not shocked at the same time.  This man was 100 percent invested in company stock.  This is about the riskiest investment you can have in a 401(k) plan.

This man was a US citizen who had immigrated to this country many years back.  With a native tongue that was not English, he was sometimes confused when discussing the more technical aspects of financial dealings.  So he relied more heavily on the opinion of those people who portrayed themselves as experts.  Before his recent foray into using a financial advisor, he essentially used the advice of his employer, the plan sponsor, by accepting the default investment.  In this case, the default was company stock.

Plan sponsors can’t do this anymore – use company stock as the default investment when their plan participants don’t choose their own investments.  This was one benefit of recent disasters where participants lost their life savings when the value of their company’s stock plummeted to zero.  The trend now is to use a life cycle fund as the default, or a very conservative investment.  But this trend change was too late for this man’s original investment choice.

He was fortunate in that he worked for a stable, growing company, whose stock value had increased significantly over time.  However, besides the lack of diversification, this man had one year to go before retirement.  Very aggressive investments were inappropriate on both counts.   Obviously, his financial advisor quickly had him move to much safer investments.

You’d think he’d be happy now, right?  Turns out he liked the rapid growth of his retirement account.  He rather grudgingly accepted the wisdom that conservative investing was appropriate for his life stage and risk tolerance, not liking the reduced rate of return.  But he still had no framework for risk of loss.  Attracted to and overconfident in strong growth (and outside of the advice of his financial advisor) he invested $5000 of other money in the initial public offering of his son’s company.

The IPO opened at $50 per share.  Within a day or two, the value had risen to $52 per share.  After the initial excitement, however, the value settled down to around $49 per share, where it has been holding steady.  At 100 shares, he is now sitting on a book loss of about $100.

Has he complained?  Oh, yes!  Yes, he has.  You see, he is indeed a very conservative investor, having conniptions over an unrealized book loss of 2 percent.  Even though he doesn’t need his investment back, he now wants to sell immediately, not trusting the value to rise up again.

So why the flip flop?  In a word, greed.

Risk vs. Reward

There is no room for greed in investing.  In the investing world you can’t have your cake and eat it, too.  If you want the reward you have to take on the risk as well.  Put another way, you have the potential to be rewarded for the amount of risk that you take.  Notice I said “potential”.  Reward is not a guarantee.  The reason is risk.

To illustrate, let’s look at a savings account.  The interest on savings accounts nowadays is so low it might as well be non-existent.  Your deposits are also federally insured, so there is little risk of loss.  So a savings account would be a baseline investment, illustrated by a flat level line.

Let’s step up the risk.  An investment-grade bond has the potential for higher return than a savings account, but also the potential for higher loss.  The swing can be measured as going above and below the baseline.  For an investment grade bond, the swing will be fairly narrow.

A high yield bond offers the potential for a higher return than for an investment grade bond, and also a higher potential loss.  So the swing on a high yield bond would be wider.  A stock offers an even wider swing than that, with greater potential for both gain and loss.

In short, you have a diagram that looks like this:

The farther out you go in risk, the greater the potential for gain or loss.

I think you’ll agree you’re like most people.  Looking at reward only, you want the biggest reward you can get.  Who wouldn’t?  The question then becomes, how much are you willing to lose?

Ah.  That is the crux of the matter.  It’s the reason why risk tolerance questionnaires focus on how you would react to a downturn in the market, instead of focusing on your reaction to an upturn.  Because this is where your true colors come out – when you are facing the loss of something precious to you.

Investors who have trouble contemplating potential losses should not be aggressively invested, no matter how much they desire big returns.  Investors who are comfortable taking on risk, and who have the capacity to withstand a large loss should it come about, would be fine investing aggressively.

The problem comes in when investors don’t fully understand or appreciate risk.  Take the man in my tale.  In not paying attention to his 401(k), he missed the impact of the ups and downs of his company stock’s market price over time.   He just saw that he started with nothing, put a little money in each paycheck, and ended up with a large chunk of change.  It wasn’t until he invested in the IPO and watched the price go up and down, and saw the impact on his invested principal, that he fully comprehended this thing called risk.  Now he knows for sure that he’s a conservative investor.  And he has stopped squawking about the conservative returns on his 401(k).

His financial advisor celebrated with a slice of pie.