What’s your tolerance for risk?
Some people see risk and see only danger: lions and tigers and bears, oh my! Others look at risk as an opportunity for an adrenaline-rush: backflips off cliffs into mountain lakes, bungee-jumping off bridges and buildings. Risk is an integral part of finance. Different asset classes have different levels of uncertainty regarding their underlying cash-flow. This uncertainty translates into a risk-profile.
We’ve discussed before how there are three major asset classes. Bonds represent a senior claim on cash-flow. They’re first in line if things go wrong. Real-estate is a claim on operating cash—rents, leases, and mortgages. And stocks are a residual claim. They get what’s left over, after other obligations have been met—but they also benefit from any growth. The more senior the claim, the more certain you can be of getting your money back.
It’s sometimes said that risky portfolios return more. That gets the equation backwards. In order to receive a higher return, you have to go down in the capital structure. Residual claims on cash-flow get the growth, but they also get wiped out in bankruptcy. Higher potential return equates to higher risk. It’s true within a company, and it’s true in an economy. The more senior claims in an economy’s capital structure tend to have lower potential returns.
Victorian explorers may have gotten a rush from crossing deep chasms on rickety bridges, but they didn’t take their families along. They understood that the upside of fame and fortune came with a big potential downside.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!