has Anyone Invented Riskless Investing?

Factual Questions
21

Not to digress too far from the OP I have always wondered whether rich investors on average get better rates of returns than smaller investors. In other words, are there investment opportunities only available to the rich that have a higher average rate of return, or does it not matter how much you are able to invest?

The old saying goes that ‘the rich get richer’, which I always thought meant the rich are able to invest in things that are less risky, yet higher return, than regular stocks and bonds. Pre public corporate funding comes to mind… but that’s certainly not without risk.

22

No there aren’t. There are some arguments that this is the case, but not good ones. Most of those arguments rest on erroneous assumptions, like failing to spot the difference between the “core” CPI and the full index.

That’s a good point.

Well, there are certainly opportunities available only to sophisticated investors, which in practice means wealthy people. Joe Q. Public can’t buy into a private placement no matter how much he wants to. Private placements offer potentially enormous rates of return, but are also risker than publically traded securities.

23

Are you excluding dividends in that calculation? The calculator you link to gives a positive (but small) return for that period dividends inclusive.

24

There are several commonly-used statistics to measure risk. You mention standard deviation and beta. Those are two very effective measurements of risk for many purposes. You seem to object only that professionals don’t define risk the same way that you do.

I’m not sure why you liken arbitrage to Russian roulette. Could you elaborate?

This is not a risk free strategy as measured by beta or the standard deviation of returns. Why would you say that the risk measures don’t work and then ignore that in your “risk free” strategy, these risk measures would do a fine job of measuring the risk you pretend they won’t capture?

You’re right that there is no risk-free investing as most people understand the term, but you haven’t supported your statement.

25

Really Not All That Bright already mentioned that in the U.S., the rich (i.e., accredited investors) can get access to some investments that poorer people can’t. You already note that some of those investments are not without risk. I’ll go just a bit further and say that the types of investments that are available to accredited investors but not to other people are generally far riskier than run-of-the-mill bonds and equities and there is no compelling evidence that they generally earn higher rates of return. Here is a case though where the greater risk means that some of those investments earn astounding rates of return and you read a lot more about those investments than you read about the myriad similar investments that lost 100%.

26

No, I’m including dividends and adjusting for inflation. According to the calculator, for the period from January 1 1966 to December 31, 1982 the annualized return (ignore the arithmetic “average” return) was -0.07%.

17 years of 100% equity risk with absolutely nothing to show for it.

27

The rich are more likely to invest by starting businesses or being early investors in them. These are much higher risk investments than most others, but the rich are more capable of absorbing a loss and diversifying enough to even it out.

More generally, the additional returns on risky investments tend to exceed the amount required to make the expected profit the same. (E.g. a near-riskless investment might return 3%, and an investment with a 1% chance of total failure might return 6% for an expected return of a little less than 5%.) That means if you can afford to invest in a portfolio of more risky investments an absorb a few losses, you can get a better average return.

28

The other question you need to ask when someone gives oddly precise end dates on a range (this is favorite of the climate deniers) is what happens if you move the endpoints a couple years in either direction? With any random data source, you’re always going to have a few years each century that are a couple standard deviations out in either direction just due to chance. If you cherry-pick those as your endpoints, you can make any trend look reversed. Move the dates just a year, and the numbers start looking different (and as noted, you can only get it negative in the first place by ignoring dividends).

Certainly that period is a valid counter-example (given sufficient caveats) to “there’s never been a period…” type comments, but it’s a nitpicky counter-example that ignores the intent. Multi-year moving averages are really the only fair way to look at numbers like this; there’s too much randomness in the mix to get a good feel for it, otherwise.

29

I have always known that risk goes with rewards. Supposedly, a Rothschild once remarked : buy when there is blood in the streets". So suppose you adopt a strategy of maximum risk/maximum reward. You buy discounted Greek bonds-on the off chance they will pay off. what can you balance this extremely risky investment with?

30

RNATB:

No. I think there are some good ones. You might have asked what they were before you dismissed them.

Basically, it’s one of those “the government is going to run out of money due to escalating entitlements” arguments. Those entitlements are tied to inflation as measured by CPI. The argument is that it would be political suicide for anyone to suggest cutting any of these, but you can ameliorate their effect on the government budget by understating inflation. There are several mechanisms built into CPI that could allow this to be done.

The first is by noting that a computer today may cost less than a computer bought in 2000 (this is just a hypothetical example.). That computer is quantitatively far superior to the computer you would have purchased in 2000. In fact a $500 Dell today, might have cost $100,000 in 2000 if it had the same specs. Therefore over the last 15 years computer prices have deflated 99 1/2%. Cars are better too. You need to account for the fact that a car purchased today can be a far better machine with more features than a car purchased for the same price in 2000.

The accounting for this in the CPI is necessarily subjective, subject to politics, and is a potential fudge factor.

Another way to manipulate the CPI is through substitution. What this means is that if you buy a Twinkie and look at the package it may say something like “contains one or more of the following: Dextrose, corn syrup, maltodextrose, cane sugar, etc”. These are all just sweeteners. Hostess buys whichever one is cheapest and puts that in the Twinkie. If they just used corn syrup than 5 years ago when there was a corn shortage they would have had to raise the price twinkles, but they could switch to a molasses based sweetener and keep the price stable. That way, acute effects don’t alter the pricing, and Twinkie eaters stay happy.

In managing the CPI it is assumed that people can do the same thing. Hypothetically, a TBone steak might be part of the CPI. Let’s say there is inflation and the price of that steak doubles because of it. If you are charge of the CPI and wish to understate inflation you could say that this is just a temporary market condition creating a price spike, not inflation. You could substitute a pound of ground chuck for the Tbone. If the ground chuck costs what the Tbone used to cost then you can say “see, ground chuck is the same as steak and ground chuck is still cheap so there is no inflation.” Then you just substitute ground chuck for steak in your CPI calculation. The mechanism by which this happens is also necessarily subjective and subject to politics, manipulation and what have you.

These are just two examples of ways in which the CPI can be manipulated to understate inflation. There are several others. Financial analysts, traders, economists and others watch closely to see if they think this is happening and if the CPI is being manipulated. The general consensus in this community (of which I am a part) is that this is happening, and real inflation is significantly higher than is reported by either CPI or Core CPI.

That’s the one I was thinking was a good argument, not the strawman you addressed.

31

Of course I specifically picked those endpoints. If you knew anything about investing you’d know that 1966-1982 was a famous bear market.

Not “nitpicky” at all, I disproved the (all caps) claim “There has NEVER been a long-term period in which the stock market failed to go up by a considerable degree–even after taking inflation into account.”

32

[quote=“Tired_and_Cranky, post:24, topic:728069”]

There are several commonly-used statistics to measure risk. You mention standard deviation and beta. Those are two very effective measurements of risk for many purposes. You seem to object only that professionals don’t define risk the same way that you do.[\quote].

Actually, they do. Both Beta and S.D. Are ways of measuring historic volatility, not risk. They are often used as proxies for risk. People get this confused, which is why it says “Past performance is not an indicator of future returns.” In the small print at the bottom of the handout which is dedicating to suggesting the exact opposite.

“I’m not sure why you liken arbitrage to Russian roulette. Could you elaborate?”

It doesn’t always work. Those differences between markets are usually minute when they occur. Millions of dollars needs to be pushed through the trade to yield a few thousand. These trades are subject to operator or programmed error, bad ticks, deliberate fraud, people setting arbitrage traps, etc. in practice it’s very risky.

I didn’t suggest that the strategy was risk free in terms of beta or SD. And, I thought it was clear that I thought those were both mad measurements of risk. I brought up the strategy as a way of eliminating a risk, in that case 10 year principle risk.

Thanks. I know I’m right, though. This is a complex subject, and I didn’t really expect to prove it in a couple of paragraphs. It was more about providing food for thought.

33

Sure, but any given portfolio reflects the market only so accurately, and finding that ideal “market basket” of securities is more art than science, and as such, is akin to gambling. This is because you can put your money in, but nobody can guarantee that you’ll make 7% over time. You may make 9%, you may make 3%, and the less diversified you are, the more likely you are to see fluctuations and the like.

I agree that most people are way too emotional and focused on the present/near future to be good investors though, precisely because they do things that increase their exposure to market fluctuations, and then act on those fluctuations when they probably should just ride them out.

I mean, if you had something like Eli Lilly or AT&T in 2006, it would have been smart to hang onto those stocks, even if they dropped in value due to the 2008 recession. This is because those companies are fundamentally sound in business terms, and are likely to regain value as the market returns to normal. In other words, the loss in value had nothing at all to do with the companies themselves- it was a market-wide downturn. If anything, the smart thing to do would have been to buy those as much as you could.

But a lot of people tend to get crazy and think “ZOMG! My stocks are decreasing in value! All hands on deck- let’s do SOMETHING to stop this”, even when the smart move may be to hang onto them and ride out the downturn.

It’s fundamentally the difference in thinking that stock gains and losses are real vs. the idea that they’re essentially fictional until the moment that you actually sell those shares. I keep hearing people say stuff like “I lost X amount”, when in reality, they didn’t sell those shares, so they didn’t actually lose squat.

34

It’s been a while since this mattered to me professionally, but I think you have the effect of substitution on CPI backwards. Potential substitution is said to mean that CPI is artificially biased higher. When the price of T-bone steaks doubles, government economists have to shrug their shoulders and say that the T-bone steak component of their price basket doubled and inflation is accordingly higher. But individual consumers will just substitute cheaper ground chuck for T-bone steaks to keep their food budget the same. So the inflation they experience is, in fact, lower than the government’s estimate.

35

[quote=“Scylla, post:32, topic:728069”]

That’s fair and I guess I expected too much of a short post. Thanks.

36

People do tend to sell their shares at the first sign of danger and many of those people would be better off holding on longer. It’s a good idea to teach people not to panic in downturns. Your suggestion that losses aren’t real until they are realized leads to a different error in decision-making: your thinking leads people to hold onto losing stocks even as the companies circle the drain because they think that they’ve only lost once they sell. I think people should realize that if the stock price drops, they have lost the money in the stock. The question for the stock owner is then basically, having liked the stock at, let’s say, $100 per share, with a price now of $90 per share, would they still have bought the stock? Sometimes, new information comes out that makes it likely that the stock that went from $100 to $90 might continue to drop. Sometimes, the market just drops and the $100 stock is now on sale for $90. Your reaction to those two different scenarios shouldn’t be the same. And it shouldn’t depend on convincing yourself that your losses are only real if you sell.

37

Fact is, the OP’s question is pretty much analagous to “Has anyone invented a perpetual motion machine?”

38

[Nathan Mayer] Rothschild was talking about the Panic of 1873, which depressed the worldwide economy rather than just one or two. His point was that over time the markets would recover. I doubt he would have invested in Greek bonds, but he would have been buying US stocks in 2009.

That’s a reasonable argument, but I still wouldn’t say it’s a good one. For one thing, all BLS numbers (including the CPI) are vetted by the OMB. We’re talking about thousands of people; if there was a conspiracy to artificially depress the CPI some of them would be talking about it. Second, the effectively independent Fed would have stopped using the CPI in its interest rate setting procedures because it has no political masters and has no stake in depressing Social Security and TIPS adjustments.

39

To answer the OP, no, there is no such thing as riskless investing. Bernie Madoff’s investors lost their money as a result of believing that there was.

40

No you didn’t. 17 years is on the long side of medium-term. It isn’t long-term. A 30-year-old has two 17-year periods in his life before he reaches retirement age.

For more information, see this publication from the Kansas City Fed.

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.482.7678&rep=rep1&type=pdf