Of Risk and Return (Part 3)

How do we control risk?

Photo: Douglas Tengdin

Good investing is like good building. You can’t really judge the quality of the work until something goes wrong. This summer we’ve been remodeling our kitchen. It’s been an adventure. Changing the flooring exposed our plumbing (I’m not making this up …), which needed to be brought up to code. As we got into the project, other areas had to be addressed—electrical, insulation, windows. We found that our quirky house had a lot of issues—issues that weren’t visible, but might 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 looks 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 something happens—say, interest rates go outside of a narrow band, or prepayments on mortgages rise, or stock prices fall (again, I’m not making this up …), the coupon payment goes to zero.

In financial parlance, 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 can make their funds look pretty good. 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.

Photo: Butkovicdub. Source: Morguefile

That’s why risk is so hard to see, and why it can’t be reduced to a single number. These bonds were bombs just waiting for the right trigger 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, our funds didn’t blow up, which was a credit to my boss, Bentti Hoiska.)

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—or more than 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.

Photo: DuBoix Source: Morguefile

Eventually, our kitchen remodeling will be finished, and many parts of our home will be brought up to code. In building as well as investing, you need to have someone who can spot potential problems before they became outright disasters.

Douglas R. Tengdin, CFA

Chief Investment Officer

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