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Understanding Risk

I was sitting with a friend recently and I asked him what he thought of today’s investing world and how he was investing his money.  He told me that he had some real estate investments in partnerships with people he knew and that he had some money in bonds and some even in stocks too, although he knew those were fully priced.  I pressed him on the bond allocation, because at today’s rates I find it very hard to understand why anyone prefers a bond to cash.  The after-tax return just seems like too little to part with the flexibility of having the dry powder.  My friend told me that he had a portfolio of highly rated bonds of varying maturities, with a healthy share being of the 10-year and longer maturity.   He explained to me that he was invested in these because he was seeking to avoid risk, given that stocks and other financial assets seemed to be so fully priced.  I felt so sorry for him at that moment because he, not being an investment professional, was making a fundamental mistake of being focused solely upon credit risk.

It is 100% true that my friend’s credit risk profile was well served by his allocation to longer-term highly rated fixed income securities.  If, or when the stock market retraced some of its recent runup he might be reasonably well insulated.   However, unknown to him, he had traded credit risk for duration and price risk.  As I survey the investment world, it strikes me that my friend is not atypical in his misunderstanding of investment risk.  I see many in today’s market making similar mistakes, both novice investors as well as professionals.  
 
Duration risk is the risk that in a higher rate/return environment investments with longer maturities/durations such as longer term bonds (or certain equity investments)would lose significant value, leading to acapital loss for those who sell before maturity or foregone opportunity costs for those who have locked up their money for a while in what would then be considered to be below-market returns.  Price risk, which is the cousin of duration risk (if not the sibling), is the risk that prices of whatever it is that you’re buying have been bid up so high that the chances of a correction are quite high.  One can buy great quality assets but if one pays the wrong price for it then that is quite risky indeed.  Ask the investors in Stuyvesant Town, the rock solid portfolio of apartments in Manhattan that some of the smartest real estate investors in the world managed to lose billions of dollars on in 2008 because they paid far more than the asset than they should have.
 
As my friend Geoff Dohrmann is fond of saying, “It’s a whacky world out there.  Be careful.”  Price risk and duration risk are no less important or risky than credit risk.

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