Managing risk may be one of the most important aspects of being a successful investor – the risk reward ratio is something you need to understand deeply in order to figure out which of the many investment strategies works best with your appetite for risk.
In basic terms, the more risky an investment, the more upside you should have to consider it a viable option.
The problem is that risk comes in multiple forms, and is nested within itself depending on what strategies you’re employing.
Risk changes depending on what you’re doing – sometimes it’s market conditions you’re betting against, sometimes its founders, or even the business concept itself is in question.
The more variables you need to consider, the higher the risk.
One key to managing risk is to pick a strategy and stick to it – listening to multiple people and half-stepping into lots of things is an easy way to create an overly complex structure that’s hard to manage and more likely to breakdown in stressful market conditions.
Savings:
Keeping your money in a savings account is probably the lowest risk instrument you can use to ‘grow’ your wealth, and the risk here is low because the big hits to your wealth would only come in catastrophic situations: where the value of the dollar tanks, or your bank goes out of business and steals everyones money.
Even in that scenario, your savings account is insured by the FDIC for $250k.
These are very unlikely scenarios, so the risk attached to keeping your money in a savings account is very low.
To follow that very low risk, you can expect to get 0.05% annually in a savings account at todays rate, which is pretty low.
In fact, it’s actually lower than the current inflation rate of 0.85% per year – so keeping your money in a savings account puts you on the wrong side of inflation – not great.
The way a savings account works is you put your money in a bank – and now the bank has liquidity to go use this money and lend it out to other people.
When someone goes to the bank and gets a 30 year loan at 4% – the bank is taking a little bit of your money, and a little bit of everyone else’s money – and loaning it to that person. The bank will make 4%, and they’re paying you 0.05% to hold your money with them. So at the end of the day, the bank makes money, and you make a tiny bit of money.
The person with the most risk in this transaction is the person taking out the loan – they’re on the hook for the initial amount + 4% / year for 30 years.
The bank manages risk by doing this with thousands of people – so if one of the loans fails, they’re still profitable on the other ones – and they also now own a foreclosed property at a huge discount which they can sell to recoup the initial investment.
Bonds:
In terms of active investments, Bonds are probably next up on the list in terms of risk.
Within bonds, there’s a bunch of different products you can choose from – the higher the risk, the higher the interest rate, usually.
If a bond is ‘secure’ that means it’s insured by some 3rd party, so in the scenario where the bond issuer cannot pay back the principal, the insurance would cover the losses. This lowers your risk profile, because you don’t even need to trust the issuer to be confident that you will get paid back. You would need to trust the insurance company though.
A non-secure bond means that the bond is not insured, and so likely comes with more risk and a higher rate.
Treasury bonds are issued & backed by the US government, Municipal bonds are issued & backed local governments, Corporate Bonds are issued & backed by companies, etc.
The most recent Treasury bond was a 30 year 2.75% interest bond – so much higher than a savings account, and probably a similar amount of risk.
The difference is with a savings account, you get to keep your liquidity (i.e if you see a piece of real estate you want to purchase, you can go do that). If your money is in a bond – it’s locked for 30 years.
So much better interest rate, but less liquidity.
Stocks, Options, Commodities, Lending:
These all have various risk profiles, but generally the same types of returns if you start at an Index level.
An index is a financial instrument that allows you to hedge your bets across a large industry.
There are indexes of the S&P 500 which just buy every company – so you’re moving with the market as a whole.
You can also drill down and choose a specific niche – maybe it’s gold, or banana futures, and you want to own the entire space.
Instead of researching a specific gold company that may or may not work – you invest in the entire pipeline, so you’d own some of several mining companies, some refinery companies, a few prospective goldmines, and the top 3 gold retailers.
In the event that gold goes up and you were right, you don’t want to put all your eggs in one basket that could explode.. Instead you manage your risk by diversifying and putting your money in multiple companies within a specific niche.
This way you protect your downside, but also still participate in the upside bet you’re making in golds future value.
So indexes are a great way to hedge your bets, which is probably the best way to manage risk in a somewhat risky environment.
That said – just investing in a bunch of stock indexes actually becomes non-diversified at a certain point, because all your money is still in the stock market and betting that the market in general will go up. But recessions happen, so you need to have your money hedged in multiple different places to be fully diversified.
At this point our risk profile is becoming nested – because we’re managing risk by buying indexes, but also managing our risk by putting some money outside of the stock market – in bonds, real estate, or something more risky.
In the stock market – its not unusual to see a company move 2-5% in a single day.
So the volatility here is quite large – we were looking at making 1.5% / year in a savings account, but in the stock market we could gain or lose more than that in a single day.
Now we have more risk – we could lose a ton of money, but also a lot of reward if we are successful in loosely predicting the future.
Real Estate:
There are only a few things in this world that are finite – land is probably the scarcest of them.
The big problem with buying real-estate is you need to hit a critical mass of liquidity before you can get afford to get a loan and purchase a property.
At the end of the day – one of the only true assets you can own on earth is land. There’s only so much land – and there’s more people every day.
Within real estate there’s a gradient of risk that you can choose to take on.
The most conservative real estate investment would be to invest in the market itself – you can do that through a financial instrument called an REIT.
A REIT is a real estate investment trust – it’s basically a company that owns significant amount of income producing properties, and you purchase a little of all of them. So if one property in Texas has an issue, it doesnt really affect the portfolio at large. The value moves with the general real-estate market.
You can expect to make 7%-10% investing in a REIT with a strong real-estate market.
Adding a bit more risk, but still conservative – you can purchase a property yourself with a good cap rate, which means that the property returns x% on your money every year.
So if you purchase a $1,000,000 with a 5% cap rate, that means that the property generates you $50,000 per year in income ($4,100 / month).
If you take out a loan at 4% per year, you’re profiting around 1% per year on the existing cap, and also own a building whose value is increasing slowly over time.
As you make improvements and increase the rent, the cap rate increases, and thus the value of the building to a new buyer.
Getting riskier – you can choose to develop a property.
In this scenario, we’re not only fighting the market in general, but also your skills as a developer, and deal-specific terms that can turn a non-risky investment into a risky investment simply with the addition of one bad term.
If you get a loan with a pre-payment penalty, you’re going to be in for a bad surprise one day when you figure out what that means.
If you purchase a property that’s zoned HPOZ, you’re going to have a bad surprise one day.
If you purchase a property that has easements, or sold the rights to the minerals, you may have a bad surprise one day.
The point here is with real-estate, the biggest risk is your own understanding of every small deal point and every small issue with the property.
You have to play to your strengths and find a property that plays along with what you’re good at and what you know.
If you’re good at building on flat land – don’t purchase a property on a hill. It’s a completely different game, and will increase your risk significantly.
The risk isn’t in the property itself – the land on the hill is the same, but your ability to execute the project now affects the risk profile.
If you can hire a team and execute the property successfully – than the risk for you to purchase that property is lower than someone else competing to buy the same property.
This means its a good deal for you in this instance, and you should be competitive in your offer to purchase the land.
Black Swan, or Power Law Investing in Venture Capital:
This is the highest risk strategy, with the highest payout when you’re successful.
It’s betting 00 green in roulette. It pays out 35:1 , so that means if you can win once every 35 times – you will break even.
If you can figure out a way to systematically win twice every 35 times – now you have an interesting strategy.
The goal here is to tilt the odds in your favor so you can make an unlikely event happen more often than the statistics say they should.
When looking at startups – theres lots of elements to consider.
The first is the actual space, do you think it’s something people will actually use in the future?
And if so, will people use this company, or a competitor?
If they would use this company, are the founders capable of growing a company (hiring, managing, finding more investors, etc.) successfully?
And if the founders are capable, what are the terms of investment?
All of these questions come into play when considering ‘black swan’ investing – but the most important is if the company can become your black swan in a best case scenario.
In other words – whats the ceiling of the company.
If the company is amazing, great founders, product design is perfect, etc. – but the company at best is attacking a $100m market, then it would not make sense to invest within a strict black-swan strategy.
The singular goal is to find outliers who can achieve a $1b+ exit. If you can hit 1 in 35 in roulette, your one win will cover all the losses, and generate a significant profit.
My Personal Strategy:
I believe that in the next 10 years there’s going to be a transformation in the way our society works.
The technological building blocks for automation are here today, and these future robots will replace many of the jobs that are repetitive, dangerous, or boring.
The flow of capital will move from people earning wages, to the companies who own the robots that replace those jobs.
In order to hedge against this future, I’m focusing full time on investing in Automation companies through: The Automation Fund
The basic question is: how do you maximize returns and minimize risk.
In this case, we’re operating in arguably the most risky investment vehicle, where statistically 99.9% of companies fail – but our goal is to turn the odds in our favor though several key strategic advantages.
With a $5m fund, and a standard investment size of $100,000 – this gives the fund 50 investments with which it needs to find a ‘black swan’ event.
So we’re looking at ideally a 2% success rate.
If a standard seed investment is at a $5m cap – a $1b exit returns roughly $20,000,000 to the fund.
So one black swan exit = $15m profit, and it covers the costs of the 49 other companies that hypothetically failed.
Now the question is how do we turn the statistics on their head and achieve a greater than 2% success rate.
That’s the billion dollar question – and one that I will expand on in future posts.
– J
ssb
Mar 9, 2018 -
Sound investment advice. Perhaps at the end, high risk you could also add cryptocurrencies.