Wednesday, October 12, 2011

Risk Free: A Letter to a Friend

A good friend from high school, knowing of my interest in the markets, wrote: "Are there any stocks/bonds, etc. that are 'almost' risk free and have a return of 4 percent or more? And no this is a serious question!".

That question goes to the heart of money management and trading. Everyone dreams of finding the perfect investment where he or she can park the cash and let the money roll in. Reality is quite different.

My friend's question is in fact where I started years ago when I was trying to figure out how to manage my capital, and I think the issues raised must be faced by everyone who trades.

And that category, nowadays, includes everyone with a job that has a 401(k). Ultimately, all people who have managed to land a job with halfway decent benefits are traders, whether they know it or not.

For me, it's an endlessly fascinating subject. Here is how I replied:

Your simple question actually opens a Pandora's Box of complexity.

The first risk that any dollar-based position faces is inflation. Forward inflation, based on 5-year government bond prices, is 1.7%. That means if you do nothing with your money but put it in the cookie jar, your cookie-jar position is losing 1.7% a year. Over the long term, that's quite substantial.

So your 4% return target represents a 2.3% real return, adjusted for inflation. Any position that doesn't return about that amount above inflation is scarcely worth holding. Two percent, historically, has been the real rate of return (after inflation) on bonds having little default risk.

(Terminology: I use the word "position" for any investment or holding, be it stocks, bonds, futures, currencies or $20 bills buried in a tin can in the back yard.)

With that background, let's survey the available choices.

"Risk free" means that you get as much money out as you put in; that is, your principal doesn't decline. Ignoring inflation for a moment, there are only four risk-free positions in the United States: Cash, Bank certificates of deposit (CDs), 3- and 6-month Treasury bills, and U.S. Savings Bonds.

There was a time, not so long ago, when real estate was considered to be a fifth risk-free investment. But with the collapse of real estate prices, those days are no more, at least for now.

Of today's four "risk-free" positions:

Cash has zero return and so loses 1.7% a year to inflation.

Five-year CDs pay around 1.7%, so they keep even with inflation but give no real return.

The short-term T-bills have a yield of 0.02% for the 3-month and 0.05% for the 6-month -- barely enough to put a dent in inflation.

U.S. Savings Bonds are an amazingly good deal, actually. Series I Savings Bonds pay 4.6% at present with no risk to principal, but they're hedged in with all sorts of restrictions and have a tight limit on how much any individual can invest in a single year.

Of course, any bond pays full face value if you hold until maturity. But for the government bonds (where there's no default risk), an investor needs to go pretty far out to get a guaranteed return of principal. The 7-year bonds yield 1.71%; 10 year bonds, 2.21%; and 30-year bonds, 3.19%. None pays 2% over inflation, my minimum target for any position.

High-yield corporate bonds, such as those in the fund that trades under the symbol JNK, have excellent returns. But they have lower ratings from Moody's and the other agencies -- they're called "junk bonds" -- and so there's a greater risk of default.

I'm reluctant to buy bonds at all, myself, because with interest rates so low (zero to 0.25% is the Federal Reserve's base interest rate), the only direction they have to go is up. And when rates go up, the principal value of bonds goes down, if they are sold prior to maturity. If your money is in a fund, like JNK, there is no maturity.

Real-estate, formerly considered to be risk free, has many advantages in life -- generally better facilities compared to rentals, freedom from annual rent increases, and the mortgage-interest tax deduction. It has one huge advantage as an investment -- leverage. There is no other position where middle-class Americans can put down so little cash for so much potential equity.

But as an investment -- a position -- real estate's biggest disadvantage is a lack of liquidity. I can always sell a declining stock; I may be stuck with a declining house for a very long time. A second disadvantage is the carrying cost -- mortgage interest, the property tax, insurance, maintenance. It is with good reason that a 1986 film about a newly purchased home was titled The Money Pit.

So the short answer to the risk-free part of the question that leads this essay is: No.

My answer to that lack has been to embrace risk to gain higher returns, and to mitigate the risk however I can.

For me, embracing risk means (among other things) buying dividend-paying stocks, and buying stocks and then selling covered calls against them. (I won't go into the riskier plays I that I do, such as day-trading currencies and all sorts of complex options constructs.)

Both strategies have significant risk to principal. But the combination of a stock dividend and capital gains can provide double-digit returns. Selling covered calls -- the most lucrative strategy in my playbook -- can easily provide more than 30% a year.

Or, if the market moves against you, not. You'll lose money with these strategies. The goal is to gain more than you lose over time. It's a measured approach, but it can be a bit white-knuckle at times.

That gets to the question of mitigating risk.

First, I go for the high returns. I think of returns not as cash in hand but rather as a way of lowering my basis -- what I paid for the stock in the first place. The lower the basis, the less chance of a loss there is and the greater the profit when the position is sold.

Second, I'm strict about position sizing. I limit my risk to 1% of total investment holdings in the case of any one leveraged position such as stock options, and 4% of the total in the case of shares in a single stock.

Third, I do my homework. I pay close attention to the charts and also to analyst opinion and the financial state of the company. I want all of those factors to be working in my favor.

Fourth, I trade in liquid stocks. It's rare that I hold a stock with volume under 3 million shares a day.

Fifth, and most important, I actively manage my positions. I'm mentally engaged with the markets every day. Most people want to buy a position and hold it for the long term as the money rolls in. I've found that strategy to be a way to lose money.

Market wisdom says, Stocks have always made money over the long run. Market liability lawyers say, Past performance is no guarantee of future results. And market cynics say, Long run? We're all dearly departed in the long run.

So my bottom line is this: Although there are no risk-free returns, it is possible to gain substantial returns through aggressive management of positions.

In your case, for example, it might well make sense to talk to your financial advisor about putting a portion of your holdings into riskier ventures, rather than limiting yourself to CDs and real estate.

If you want to manage the money yourself but are pressed for time, put a portion in stocks and trade in and out according to a simple system, such as a moving average crossover strategy.

The long write-up on how I trade is my "How to Be a Private Trader" essay on the website.

There are any number of good books on the subject of trading. Even if you're not managing the money yourself, it helps to have some background in order to deal intelligently with your investment manager. The "How to Be..." essay has a reading list, but the best way to get the latest is to browse Amazon.

Other reading from my website:

A recent analysis of NLY, a high-dividend stock.

Thoughts on the fallacy of gold as a store of value.

Some broad thoughts on the nature of the markets.

Thoughts on the limits of chart analysis.

These were all written as daily postings, responding to the needs of the day, and so will seem a bit dated. But they do reflect my thinking about the markets, which differs from that of most people.

Anyhow, that's my spiel, probably longer than you expected. I love this stuff so much I can ramble on forever.

Good luck!


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