The problem is that these approaches are both based on misplaced herd mentality, and both fail to make a realistic evaluation of risk/reward at the time of investment, which is the key to successful investing.
Definition of ‘safe’
Let me explain what I mean, first, by examining the nature of what are often termed low risk investments, low-yielding bonds, for instance.
Let’s say that a ten-year gilt is running at a yield of 1.7%, with real inflation at about 4%. With the yield at that level, there is virtually zero potential capital reward. No potential reward should equal no potential risk, right? Well, no. What about the locked-in risk that the investor will certainly lose money, in real terms, over that period (unless we enter a deflationary spiral)?
And what about the risk that inflation will rise yet higher, making that 1.7% return go from puny to punitive, in real terms? And that’s to say nothing of the now all-too-apparent risk that what had looked a sure bet – as certain sovereign debts and mortgage-backed securities once did – will suddenly become anything but that.
Has the investor really assessed these risks, and decided that a 1.7% return adequately reflects the risks being taken? In my view, the answer to that is often “No”.
Likewise, when the market has been flying for a while, so-called high risk assets can become very fashionable. But this is not because they have become any less risky and, as their price is far higher, the potential reward is, naturally, lower. Yet still investors pile in.
We are now in a situation where those same stocks – whose ultimate value is still largely driven by exogenous events, such as exploration successes or starting production and positive cashflow – are often quarter the price they were five years ago. Yet now, in spite of the potential reward being far higher (because of the price you can buy them at), they are viewed as being less, not more attractive on a risk/reward spectrum.
Hedge against turmoil
This is emotionally understandable, but not logical and it is my strong belief that even cautious investors need to balance their portfolio by looking for a range of investments with a well-balanced risk/reward profile. That means hedging against the risk of further market turmoil, but also guarding against the inflation that, when compounded over a number of years, can eat away at wealth as comprehensively as an under-performing stock.
A few words, too, on volatility, as many investors appear to believe that the more volatile an asset class, the more inherently risky. Again, is this necessarily so? A stock which is on a steady downward path (such as, say, many newspaper companies or banks in recent years) is generally a higher risk – but may have lower volatility – than one which may swing from positive to negative and back again on a regular basis, but which may produce a return of 100% or more.
Finally – as most investors are not day-to-day traders, but are constructing at least a medium-term portfolio – can it really be safer to create heavy exposure to government debt? One thing we know for sure is that even fairly sound governments are heavily over-borrowed, and have a clear interest in inflating away the value of that debt over the next decade or more.
I would far rather see my money backing a long-term exogenous real trend: the United Nations estimates that population increases and urbanisation means that the amount of urban space on the planet needs to double in the next forty years.
Meanwhile, most commodities are severely supply constrained. For example, as copper grades available for mining have declined, they now have to mine worldwide 50% more rock to produce the same amount of copper as they did seven years ago. Commodities always go both up and down in price, but structurally-driven demand for raw materials will surely mean that it will be far more often up than down in coming years.