The Cobras of Montana
By Brad Thomason, CPA
Human beings do not do well when they have run-ins with cobra venom. This is a universal truth. Cobra venom is highly toxic no matter what your home town.
That said, folks from Helena don’t have as much to worry about as folks from the outskirts of Mumbai. It’s not that a Helenite (is that what they call them?) is immune to the effects; but rather that cobras are in pretty short supply up in Montana.
When we look at risk from the investment perspective, it is more useful to look at exposure than the elemental aspects of the thing that can go wrong. While this may seem like a strange statement, it is something that you already do in other aspects of your life, perhaps without even realizing it.
When we bring electricity into our homes, we do not change the fundamental nature of the electricity; rather we put in place counter-measures to limit how much it can hurt us if something goes wrong. We make it workable without removing its innate dangerousness. Ditto with fire. The eyes on your gas cook-top are not 36 inches in diameter for a reason.
When we talk about exposure we are talking about the combination of incidence and impact. Incidence is how likely the negative event is to occur. Impact is the degree of damage it will cause if it does.
Again, people in Montana don’t have to worry about cobras as much because there aren’t any cobras around, in the first place. The incidence is sufficiently low that the risk is essentially nullified. The exposure is pretty much nonexistent.
In portfolio design, we accomplish a similar result through the way we allocate capital.
If you asked most people whether or not trading derivatives is too risky an activity for a retirement account, I think most people would say it is.
But I also think you could make the case that I didn’t give you enough information to answer the question.
If two people had a million dollars in savings, but one had $20,000 in a trading account, while the other had $400,000, wouldn’t we have to regard that as two very different scenarios? In the end, the part that would draw our attention would not be the trading itself, but the amount involved, right?
It’s very hard for the $20,000 we have walking around in the Indian countryside to hurt the $980,000 we have stashed back in Montana, so to speak.
Risk is a sufficiently important matter that we should understand it thoroughly, and that includes an understanding of a particular thing’s fundamental potential for destructiveness. But we should also understand that fundamental potential is largely theoretical. In practice, our exposure to the risk – not the risk itself – is what we need to be thinking about. How likely it is to happen, and how much it can hurt us, are what will impact our actual results.
The sun may be a fire so hot that it is basically a floating nuclear reactor. But knowing not to take the kettle off the stove and pour the contents on your hand is a more useful tidbit for making it through the typical day.
If this were an episode of Seinfeld I would figure out some way to end this post by serving tea to a cobra, or something like that.
But it isn’t.
So just keep in mind that your exposure to risk is what matters; and that one of the primary ways to control the exposure is via capital allocation. OK?
By Brad Thomason, CPA
Consider the following situation. You have access to a supply of investments which make a stated amount of interest, and you build an investment portfolio out of these assets. Some sort of bonds, perhaps; although in reality they could be anything. But let’s go with bonds to keep it simple, and let’s say they pay 6% annually.
Question: If the bonds earn 6% would it be your expectation that a portfolio composed of these bonds would also earn 6%?
Because it might not. In fact, it probably won’t.
This is a key aspect of investment returns that people need to understand in order to make quality projections about future earnings. Yet it is a topic that I don’t see addressed very often.
To understand how a portfolio composed of 6% assets could earn less than 6%, you have to get down in the weeds of what actually happens at the mechanical level with the assets. Bonds mature (properties get sold, etc). When they mature they stop accruing interest, and it is more likely than not that there will be some lag between the day of maturity and the day that the capital is reinvested. Every time there is a maturity, this will be a factor, for all of the dollars associated with that particular instrument.
In other words, the overall portfolio can’t possibly earn a full 6% because something less than all of its capital is earning a return every day.
Professional managers refer to this as capital deployment, and the odds of capital deployment reaching 100% at any given time are often low; and even if it happens from time to time, it never stays there permanently. Turnover in specific holdings is standard practice. So some portion of the capital ends up being on the sidelines as a result of the normal investment cycle playing out.
Note that this can be a factor even if you are on the ball with monitoring your maturities and have already decided what the next investment will be. Perhaps the broker doesn’t clear the capital right away (delays are actually the default procedure under Fed regulations, and most brokers do not voluntarily advance funds before the statutory clearing period has run). Maybe someone has to mail something to someone for a “wet ink” signature. Original documents still play a big role in finance. Or it may come down to the matter of how the proceeds are disbursed: for years we have advised our real estate clients to do everything via wire transfer because large checks – even certified funds – often get put on hold by the receiving bank for a period of a week or two.
In the end, a lot of mundane stuff, all of it perfectly common place, can work together such that your capital is on the sidelines for a month or two.
If the bonds you invest in earn 6% a year but the allocated capital only stays deployed for 10 out of 12 months, that capital will only make a 5% contribution to your portfolio return for that year. The result is that the portfolio will necessarily earn less than the 6% asset yield. As a matter of simple arithmetic, no other outcome is possible.
Beyond that, there are reductions to stated yield from carrying costs. Overnight shipping, wire transfers, custodial services and brokerage fees all go into an investor’s cost of doing business. These widen the gap even farther.
Now, to be certain, there is an entire category of situations in which the investment assets actually don’t make as much as you thought they would on the return front. This too is an unavoidable outcome which from time to time comes home to roost; it is the most obvious reason that investment risk is a thing. Sometimes things don’t go the way you think they will. But the important point here is that even if everything does manage to go exactly according to plan at the asset level, it is still possible (if not certain) for the portfolio as a whole to earn some lesser amount.
So the next time you are reviewing your level changes from one year to the next, and the net winnings are less than what you were expecting, don’t automatically assume there’s something wrong with the statement or that something wasn’t properly credited to your account. What you are seeing might indicate something like that. But it could just as easily be the effect of the naturally-occurring accumulation math which lives inside all multi-piece investment portfolios.
Better still, expect it to happen, so that it doesn’t come as a shock or a source of stress.
This aspect of portfolio behavior is in turn one of the prime reasons why it is so important to be diligent about periodically updating (annually, for instance) your plan so that you can keep tabs on these impacts and others. Since even the best planning in the world can’t predict exactly what will happen, it is important to only use projections as far as necessary. When previous estimates become – through the passage of time – settled reality, it is best to throw the estimates out and recalculate with the actual data.
When you do, replacing an expected return with a lower actual return is a frustrating thing to have to do. But as I said earlier, it’s probably something you should expect to happen, at least to some degree. Moreover, perhaps you can take solace in the fact that the universe hasn’t singled you out for poor treatment. It’s something that happens to every portfolio owner from time to time.
Although it still irks me when I have to do it.
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