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Maybury

Article:

Explanation of Risk Levels

By Richard J. Maybury

From the February 2001 EWR


When it comes to money, you have probably noticed that this newsletter is more cautious than most. 
    This is not an apology. If you followed my advice about risking your hard-earned money in the Asian Tiger bubble and tech bubble, you may not have become a billionaire but you did earn a few dollars and, more importantly, you did not lose anything. 
    My advice for bubbles remains what it has been for 20 years:

    Do not risk what you consider a serious amount of money.

    Take profits steadily on the way up.

    Cultivate cowardice. Psychologically prepare yourself to bail out early and leave some money on the table. It is better to bolt for the exit a year too early than a day too late.

 The reason EWR is more cautious is that most investment analyses look back weeks or months, while ours looks back decades or centuries. We are constantly reminded of how much can go wrong, and we factor these risks into our recommendations. 
    I recently heard an announcer on CNBC refer to the next 12 months as "the long term." 
    It is my belief that investment advisors and investors became more risk-tolerant during the 1990s because they lost their understanding of risk. Then they paid for it in the collapse of the Asian Tiger bubble and the tech bubble. 
    For a clear-eyed look at risk it helps to realize that the meaning of the word investment has changed. Generally the financial industry speaks of three categories of places to put your money: savings, investment and speculation. 
    For centuries, savings meant something very low risk, and therefore paying a "real"¹ return of no more than 3-4%; often just 1-2%. 
    Investing implied more risk, and the hope for a real return of perhaps 5-7%. 
    Speculation meant a lot of risk and the hope for a real return of 10% or more. 
    A century ago the federal government issued 50-year bonds paying 4% per year. The money was gold, which is financial bedrock - gold has been valuable for 6,000 years - so investors were confident the value of their money would not change, and 4% per year was adequate compensation for the 50-year risk. 
    In the 1970s, the dollar's final links with gold were severed. Worse, governments had become so powerful that their attack on gold dislodged it from its ancient role as the standard of value by which all else is measured. 
    Now we have no standard. Gold has become a commodity with an unstable price, and the dollar is just a slip of paper that can be created on printing presses by the carload. 
    Key point: when the currency itself is not trustworthy, all financial instruments contain added risk. 
    The reality is that savings no longer exist. Everything has been bumped up to either the investment or speculative levels of risk, although not necessarily these levels of profit. 
    Even if you put all your money into the safest media possible - Treasury-bills and insured CDs - you are accepting an amount of risk that would have had most of your ancestors breaking out in a sweat. 
    Few investors or investment advisors have enough background in economic history to understand this, so most investment behavior and investment advice today contain a level of risk formally seen only at casinos and race tracks. 
    CNBC-TV has become the mainstream consciousness of the investment world. For years I have pointed out that nearly everything on CNBC is, in my opinion, in the casino category. 

    Example Risk Levels
  • Gold coin in 1875: 1
  • Treasury Bill: 2
  • Federally insured short-term
  • CD: 2.5
  • Stock in Cisco, Microsoft or General Motors:4.5
  • Stock in General Dynamics: 3.5
  • Gold or silver bullion coins: 3
  • Swiss francs in a US-insured CD: 3
  • Stock in Slumberger or Broken Hill: 3.5
  • Distant oil or gas call options: 3.5
  • Internet stocks: 4.9
  • A wager that the sun will rise in the west:4.99999
  • A wager that Hillary Clinton will turn libertarian:5

    Notice what I'm saying in this box of example risk levels. The safest place for your money ever in history was a gold coin in 1875, and a T-Bill today is twice as risky as that. A short-term insured CD is half-way to as risky as it gets. 
    Because of the corruption of currencies and the loss of understanding of risk, investment markets have lurched from one bubble to the next for three decades. I expect this to continue for the rest of my life. (I'm 54.) All these bubbles grow from the unspoken assumption that the ordinary Joe or Jane can make a fortune without working. 
    These bubbles will be heavenly for gamblers who understand bubbles and have lots of self-discipline (see the 11/00 EWR, p.2-5). For gamblers who do not understand or do not have self-discipline, the bubbles will be, well, interesting. 
    If you are not a gambler, my best advice at this time is to stick to T-Bills and short-term insured CDs, and a few precious metals coins and Swiss francs.

 

Note: The last sentence, written in February 2001, is obsolete. On 9-11, economic conditions began to change. The new environment, and a new high-security investment strategy were explained in the 2/03 and 3/03 EWRs.

 

1"Real" = adjusted for effects of inflation. If consumer prices are rising at 4% and the investment earns 10%, the real return is 6%.

2Short term = 1 year or less. Long term = 5 years or more.