Archeological dig. Public Domain. Source: Wikimedia
Good investing is like good building. You can’t really judge the quality of the work unless you look under the surface. A few years ago, we remodeled our kitchen. It was an adventure. There was plumbing underneath our flooring. Yes, seriously. When we pulled up the floorboards, plumbing came up with it. That was fun. Later, other areas had brought up to code: electrical, insulation, windows. We found that our quirky house had a lot of issues, issues that weren’t visible, but would have caused problems if something went wrong.
It’s like that when you look at investments. Unless you know what you’re looking for, you might never know about potential problems buried in a portfolio. In the early ‘90s, I managed a money-market fund. Some of the more popular instruments at that time were “structured notes” issued by federal agencies, like Fannie Mae or the Federal Home Loan Bank. On their surface, structured notes look like a plain-vanilla short-term triple-A bonds. But inside, there are some “special” features.
The bonds pay an above-market interest rate, so many portfolio managers buy them to enhance their yields. But if interest rates go outside of a narrow band, or prepayments on mortgages rise, or stock prices fall, the coupon payment goes to zero.
In financial terms, the portfolio manager sells options on an unlikely event. The agency pays for these options with a higher interest rate. By putting a lot of these into a short-term fund, managers boost their short-term returns. And the only people who know that these land-mines are there are the managers and folks who patiently look up the tickers from the funds’ quarterly holdings report. Managing risk can get pretty tedious.
House remodeling. Photo: Victor Albert Grigas. Source: Wikimedia
That’s why risk is often so hard to see risk, and why it can’t be reported in a single number. These bonds were bombs just waiting for the right circumstance to set them off. When interest rates rose in the mid-‘90s, that’s exactly what they did. Many of the money-market funds that bought them had to be bailed out by their parent companies when they “blew up.” (For the record, the funds at my firm didn’t blow up, which was a credit to our boss.)
That’s what Warren Buffett means when he says that a rising tide lifts all boats, but when the tide goes out you find out who’s been skinny dipping. Just because a portfolio isn’t volatile or doesn’t blow up doesn’t mean it’s safe. Risk control may be present in good times, but it can’t be seen because it hasn’t been tested. But it’s critical to control risk, because good times can easily turn into bad times.
But you can’t eliminate all risk. That would reduce your return to zero. It’s an investor’s job to take intelligent, manageable risks and get paid a fair return for them. Sometimes you have to go out on a limb, because that’s where the fruit is. A skillful investor welcomes risk at the right time, in the right circumstances, at the right price.
Eventually, our kitchen remodeling was completed, and a lot of our home was finally brought up to code. In building as well as investing, you need to have someone who can spot potential problems before they turn into disasters.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”