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I have some money to invest and I consider different investing options.

For instance I could:

  1. Let the money on a tax-free account 0.75% per year (the % can be changed by the state if inflation is low).
  2. Buy stocks of my employer which has a 8% dividend yield (5.3% return after taxes).
  3. Invest in an ETF based on the CAC40 index.
  4. Buy physical gold.

Each investment offer different rewards and risk. However, in some of them calculating the expected return is fairly simple, but evaluating how much I risk seems more complicated.

What is a sound way to measure the risk of each investment in order to compare them with each other ?

Should I always consider the worst case scenario ? Because when I do that, I always can lose everything.

  1. The bank goes bankrupt and I lose my savings.
  2. My employer goes bankrupt and I lose all my savings.
  3. The ETF provider goes bankrupt and I lose all my savings.
  4. There is a war, and the state decides to confiscate all gold. I lose all my savings. Or burglars break into my house and steal my gold.

Is there a way to estimate the probability of such events, better than intuition ?

Should I only consider more probable outcomes and have a plan for them if they occur?

  1. If the state reduces the rate to 0.25% I will move toward another investment option.
  2. If the stock price falls below a threshold, I will sell the stock so I can measure my maximum potential loss. (There is still the risk that my stop-loss is not executed at the expected price because of a gap at the opening...)
  3. Same with the ETF.
  4. If the state add a tax when you sell gold, I will sell it before the law is passed.
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    Which country? In the US, ordinary bank accounts are insured up to $250,000 by the FDIC; the bank going bankrupt can't lose that money. – keshlam Jan 19 '17 at 4:35
  • Black swans don't exist. Just go for it. ;-) – jpaugh Mar 25 '17 at 2:13
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Let us consider the risks in the investment opportunities:

  1. The risk is that the bank goes bankrupt. Thus, I would not save much money to one bank. You should diversify your investments.
  2. The risk is here that the tides turn and your company gets into trouble. Then, you may lose both your job and your investments. Thus, I would very heavily advise against investing in your employer. The diversification is practically nonexistent in this kind of investment, and your employer is the worst investment you can make because of the risk of both losing your job and your investments at the same time.
  3. The risk here is mainly market risk. The markets are quite highly valued now according to the cyclically adjusted price/earnings (CAPE) ratio. You do get dividends for the investment that generally rise every year along with economic growth, but the investors may valuate the value of those rising dividends differently when you need to sell your investment. If you diversify in time (e.g. buy monthly for the next 10 years), and your time horizon is long (30-40 years), the risk is practically nonexistent, because over the long term, dividends are far more important than market valuation.
  4. The risk here is that gold price does not appreciate, which is very genuine risk. I would not make an investment purely based on the premise that the value of something should appreciate.

Now, what are the returns in each of the investment:

  1. The return is interest, which is quite low. But it's better than nothing.
  2. The return is dividends, which you said are quite high. However, there may be reasons for high dividend yield (such as the expectation that the dividend doesn't grow year after year much).
  3. The return here too is dividends. In the index, the average dividend yield probably is not 8%, but it is far better diversified than the investment in your employer, and you can be almost certain that in the long term, the dividend rises along with economic growth.
  4. The return here is nothing. Yes, gold does not have a return. Stocks pay dividends, bonds pay interest, properties pay rent, forest grows. But gold does not have any mechanism of producing return. You could speculate that someday someone could pay more for the gold, but that is speculation, not investing.

What are the alternatives to these investments, then?

  1. The alternative is a money market fund. It is better diversified than an account in a single bank, and at least in the part of the world where I live (Finland), interest in a money-market fund is generally higher than in ordinary accounts. Just make sure that the money market fund is a real money market fund and does not invest in short-term corporate bonds or variable-rate loans given to banks.
  2. The alternative is a well-diversified stock portfolio. Instead of investing in just one company, invest in many companies. You have lower risk but the return doesn't suffer if we can believe in the efficient market hypothesis.
  3. The alternative is investing to many indexes instead of investing in only the CAC40 index. In this way, you gain better diversification but the returns again do not suffer.
  4. The alternative is investing in a gold mine. Physical gold produces nothing, but a gold mine is a company that pays you dividend. Thus, if you believe the price of gold is going to rise, I would invest in a gold mine instead of investing in physical gold.
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    Note that there's nothing wrong with putting some of your money in your employer's stock, especially if you can get it at a discount through an employee stock purchase plan. But that should usually be a relatively small portion of your investments. Diversification again. – keshlam Dec 27 '15 at 15:29
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    I wouldn't however invest in my employer unless I am given benefits related to it (e.g. employer matches my investments), or unless the investment happens through an index fund. If building a well-diversified portfolio by careful stock picking, I would simply leave out my employer's stock instead of putting, say, 1/20 of my investments to it. – juhist Dec 27 '15 at 15:32
  • I don't have 1/20th of my investments in any single stock. I own about 20 shares of my employer -- I should be taking the "free money" thru the espp, but some of the things that make it a good deal also make it a bookeeping nuisance and when the discount dropped from 15% to 5% I decided I was too lazy. – keshlam Dec 27 '15 at 16:34
  • Then you are very well diversified indeed. To the original poster, not having more than 1/20th in any single stock is also what I recommend, although when starting investing in individual stocks and diversifying also in time, you'll temporarily have necessarily more than 1/20th in a single stock or a while. But that's then just a temporary condition. – juhist Dec 27 '15 at 17:23
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First of all, setting some basics:

  • Risks are generally measured on a their severity and their likelihood of occurrence.
  • Risk assessment must be both quantitative and qualitative where possible. Qualitative risk assessment is a minimum.
  • Where no exact figure for a risk assessment can be produced (e.g. VaR = 10M$), conventionally a 1-5 rating scale where 1 is lowest and 5 is highest is used. This helps build a risk matrix (see Wikipedia - Risk Matrix).
  • Risk appetite is your tolerance level for taking risks (or aversion for risk, inversely). While this does not change the risk management process in itself, this is what you should ask yourself when taking a final decision: am I willing to take that risk ?

What is a sound way to measure the risk of each investment in order to compare them with each other ?

There is no single way that can be used across all asset classes / risks. Generally speaking, you want to perform both a quantitative and qualitative assessment of risks that you identify.

Quantitative risk assessment may involve historical data and/or parametric or non-parametric models. Using historical data is often simple but may be hard in cases where the amount of data you have on a given event is low (e.g. risk of bust by investing in a cryptocurrency). Parametric and non-parametric risk quantification models exist (e.g. Value at Risk (VaR), Expected Shortfall (ES), etc) and abound but a lot of them are more complicated than necessary for an individual's requirements.

Qualitative risk assessment is "simply" assessing the likelihood and severity of risks by using intuition, expert judgment (where that applies), etc. One may consult with outside parties (e.g. lawyers, accountants, bankers, etc) where their advisory may help highlighting some risks or understanding them better.

To ease comparing investment opportunities, you may want to perform a risk assessment on categories of risks (e.g. investing in the stock market vs bond market). To compare between those categories, one should look at the whole picture (quantitative and qualitative) with their risk appetite in mind. Of course, after taking those macro decisions, you would need to further assess risks on more micro decisions (e.g. Microsoft or Google ?). You would then most likely end up with better comparatives as you would be comparing items similar in nature.

Should I always consider the worst case scenario ? Because when I do that, I always can lose everything.

Generally speaking, you want to consider everything so that you can perform a risk assessment and decide on your risk mitigating strategy (see Q4). By assessing the likelihood and severity of risks you may find that even in cases where you are comparatively as worse-off (e.g. in case of complete bust), the likelihood may differ. For example, keeping gold in a personal stash at home vs your employer going bankrupt if you are working for a large firm. Do note that you want to compare risks (both likelihood and severity) after any risk mitigation strategy you may want to put in place (e.g. maybe putting your gold in a safety box in a secure bank would make the likelihood of losing your gold essentially null).

Is there a way to estimate the probability of such events, better than intuition ?

Estimating probability or likelihood is largely dependent on data on hand and your capacity to model events. For most practical purposes of an individual, modelling would be way off in terms of reward-benefits. You may therefore want to simply research on past events and assign them a 1-5 (1 being very low, 5 being very high) risk rating based on your assessment of the likelihood. For example, you may assign a 1 on your employer going bankrupt and a 2 or 3 on being burglarized. This is only slightly better than intuition but has the merit of being based on data (e.g. frequency of burglary in your neighborhood).

Should I only consider more probable outcomes and have a plan for them if they occur?

This depends largely on your risk appetite. The more risk averse you are, the more thorough you will want to be in identifying, tracking and mitigating risks. For the risks that you have identified as relevant, or of concern, you may opt to establish a risk mitigating strategy, which is conventionally one of accepting, sharing (by taking insurance, for example), avoiding and reducing. It may not be possible to share or reduce some risks, especially for individuals, and so often the response will be either to accept or avoid the given risks by opting in or out on an opportunity.

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