ARE JUNK BONDS risky? That was the question from a friend in his late 20s, whom I’ll call Josh. I answered that they were probably risky for him, but quite safe for me. Josh looked puzzled—until I explained that risk is in the eye of the beholder.
Josh has a stable career that pays well, but he doesn’t plan to stick with it forever. Instead, he wants a job that relates to his passion for outdoor activities. His strategy? Sock away as much money as possible. Once he’s done saving for retirement, he’ll switch to a more interesting job that pays just enough to sustain his lifestyle.
Josh has many years before he taps his retirement fund. He needs growth to maximize the power of investment compounding over his long time horizon. Income investments, whether FDIC-insured bank deposits or high-yield bonds, would endanger his nest egg’s growth prospects. He’s safer buying stocks and taking more risk.
My situation is different. I’ll soon start to live off my investments. I’m always looking to diversify my portfolio’s income sources. I can live with small doses of high-yield bonds, preferred stock and senior bank loans to boost my cashflow. No, these investments don’t promise price stability. But I can count on these riskier sources of income for my non-essential expenses.
All investments are risky in one way or another. But their risk should not be viewed in isolation. An investor’s own situation and objectives matter the most. An investment is risky when it doesn’t align with your overall financial goals. It’s safe when it fits well with the rest of your investments and it has a clear purpose in your portfolio.
Consider two casino games. In the first game, there’s a 25% chance of doubling your money. Otherwise, you get back just half of what you bet. The second game is riskier. On average, you’d lose all your money 99 times out of 100. But when you win, your payoff is 100 times your bet. If you walked into the casino with cash in your pocket, which would you choose?
Recently, I ran a webinar about investment risk and I presented this choice to participants. Of the 70 respondents, 40% chose to play the first game and less than 10% went with the second one. Of the remaining participants, some rejected both choices, while the rest said that their decision would depend on other factors.
Was there a single correct answer to my question? Not really. Each answer can be the perfect choice for one person and completely absurd for another. The decision depends on what each player wants, rather than on the games themselves.
Take the first game. If you don’t mind spending a few bucks to have some fun, it could be ideal. Sure, you’d lose money over time, because the expected return on each bet is negative. But the entertainment could be worth every penny.
In real life, many investments are unappealing at first glance. Some may even lose money over time. Cash is a good example. In today’s low-interest environment, its inflation-adjusted return is negative. Still, not all cash hoarders are losing sleep over their loss of purchasing power. Perhaps they value stability, liquidity and peace of mind. Cash is the right choice for them, even if it isn’t for others.
People who crave the thrill of a big win would choose the second game. To them, the potential pleasure of hitting the one-in-a-100 jackpot trumps the strong likelihood of repeatedly losing. But my webinar poll suggests that such people are in the minority. That’s because most of us dread losses. For those who don’t, the second game may be the correct choice.
An acquaintance of mine would probably like the second game. He trades TQQQ, the triple-leveraged exchanged-traded fund that’s tied to the Nasdaq 100 index. He says the perils of leveraged ETFs don’t bother him. From his perspective, it’d be riskier to give up his chance of a big win, however slim the odds are.
To understand why some poll respondents shunned both games, let’s put on our homo economicus hat. In the long run, neither game should be profitable. The first game favors the casino. Over time, a player would likely lose an average 12½ cents on every $1 bet. With the second game, a player can expect to break even over time, but nothing more. Someone who’s looking to make money would pass on both games and instead search for a better alternative.
I recently found myself in a similar spot. I needed to invest my annual work bonus. I had no appetite to invest more in the stock market, which I consider overvalued, though I was tempted by the shares of my favorite cruise line. I explored long-maturity individual bonds. But the paltry yields and the inflation risk discouraged me. Finally, I decided that this time my best course of action would be to wait on the sidelines, while I looked for alternatives.
What about the remaining poll participants who couldn’t decide which game to play? Are they overthinkers? I doubt it. Our money decisions are rarely black and white. They often depend on many factors, including nonfinancial factors. If we can’t decide, it doesn’t necessarily mean we’re indecisive. Sometimes, we simply need more data before we choose.
A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Behind Closed Doors, Neglected Child and Fatal Attraction. Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.
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Hopefully not TOO soon. 😉 Good one, S.S. I made the same choice in September.
Love Bernstein on risk: “There are risky assets, there are riskless assets, and there is an exchange rate between them. When times are good that exchange rate is low, and when blood flows in the streets, it is high.” “Make sure, absolutely sure, that you have enough riskless assets to tide you over during the bad times….”
Or Housel on cash: “…cash is the oxygen of independence…”
Thanks, David :). Still waiting for the exchange rate to rise ;).
Love the insight, David!
It seems to me that you are redefining risk as perceived risk and/or tolerance for risk.
Sanjib is definitely highlighting the emotional risk tolerance aspect of investment decision making. This is by far the most important characteristic of the successful investor. Done correctly, the math will never lie to you whereas your emotions can ruin you by only telling you what you want to hear unless you are ruthless with yourself.
My Dad was a tax lawyer and once told me that the most difficult part of his job was getting clients to tell him the truth. Attorney-client privilege notwithstanding, they often lied because of the embarrassment and this made it hard for him to help them. Much of his work involved gaining the clients’ trust to get at the truth. No doubt this is also a huge challenge for good investment advisors – which I’m glad I never got into because it’s hard enough figuring myself out. 🙂
Thanks, Langston. I absolutely agree that the emotional aspect is probably the hardest part for most of us.
I think that, in that regard, the distinction between risk tolerance and risk capacity is extremely useful. https://humbledollar.com/money-guide/what-stock-bond-mix/
To add to this, I think “risk awareness” is also an important aspect of an investor’s risk profile, in addition to risk tolerance and risk capacity (loss tolerance). Speaking from personal experience, we often don’t even realize what risks we are taking with our investment/financial decisions ;).
Thanks, parkslope. I also wanted to point out that the individual’s situation/objective/perception is as important as, if not more, than the “inherent/intrinsic risk” of the investment.
It might be interesting to also consider repeated game play and the difference between short term and long term investing.