The Wrong Side of Risk

by gilch3 min read16th Aug 202012 comments

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Financial InvestingWorld Optimization
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Part 4 of the Inefficient Markets sequence.

[Formerly entitled How to Pick the Wrong Side, which on reflection, I felt was too clickbaity. I am not your financial advisor! For educational purposes only. Read part 1 first.]

The Basic Idea of Insurance

You want protection from a risk. An insurer with deeper pockets offers to take that risk off your hands, for a price.

Make no mistake, the insurer is doing this for profit. You are indeed paying to spread the risk around, and your money will go to help the unfortunate. But the insurers take in much more premium than they pay out in claims. Is that fair or efficient? Are they exploiting you?

Money is not the same thing as utility. If there is something for sale that you want more than your money, you can pay for it with your money. Now you have less money. This happens all the time, and we capitalists don't think it's wrong. It's just business.

The big market players are not simply maximizing returns. They're investing other people's money, and the other people want a tolerable level of volatility more than they want optimal Kelly bets. Their utility is not their money. They might need their money for something else later, at a time they find hard to predict. If a fund has a large drawdown, most investors will panic and bail.

Options

Insurance also exists for stocks. They're called "put option contracts". The fund manager pays a premium to the market for the right, but not the obligation (the option) to dump a certain amount of stock at an agreed-upon strike price, within a certain time frame. If the manager exercises that right, the insurer is then obligated to buy the shares at the strike even if that's far above the current fair-market price.

Make no mistake, the insurer is doing this for profit. Why offer the contract at all, if the expected value is zero? The insurers take in much more premium than they pay out in claims. They don't offer contracts that would be a bad deal for them. The higher the risk, the more expensive the contract. But the fund manager doesn't have the choice. He has investors to satisfy, and they cannot tolerate too much risk.

So you see, over time, money flows from the investors to the insurers.

The options market is open to retail traders. You too can buy insurance. You too can be the insurer.

Which side is the better deal? What do you want?

Bonds

A bond is a kind of loan. Some entity, often a corporation, needs cash to run its business. Companies that borrow money can grow faster. Companies that don't grow fast enough are often outcompeted by those that do. They can buy more equipment, hire more employees. And use those resources to make even more money.

But business is risky. Sometimes plans don't pan out. Mistakes can be made. Competitors can do it better. Pandemics happen. (Among other surprises.)

The company may be unable to pay off its debts.

Bonds have a risk of default. To compensate investors, the company must pay a premium in the form of interest, or they wouldn't get enough investors willing to take on their risk. The more risky the business, the more premium they have to offer to get investors.

The bond market (or at least part of it) is available to retail traders. You too can loan money to companies.

Would you rather earn interest or pay it? What if there's a risk of default?

Currency

Fiat currency works like bonds do. And, in fact, loans increase the supply of money. To invest in a country's bonds, you have to use that country's currency. As with corporate bonds, a country with a higher risk of default must offer a premium in the form of higher interest to get foreign investment in its bonds.

Also as with bonds, the riskier currencies tend to be more volatile. And similarly, countries that default on their bonds will see less demand for their currency, which reduces its price.

Forex is available to retail investors. You too can earn higher interest rates offered by foreign countries.

Stocks

Companies issue stocks for much the same reason as bonds: to obtain the capital required to do their business.

Why are stocks worth anything?

Because people think they have value. That's kind of a non-answer, but sometimes there isn't much more to it than that. The markets are not always rational.

So why do people believe stocks have value? Ostensibly, it's because stocks pay dividends. And because shares convey certain ownership rights in the company. In particular, companies may be bought out by other companies, who must buy the stock for the rights. Companies have also been known to buy back their own shares.

If you own stock, you too can collect the dividends, and you too can profit from a buyout, or even from the perceived potential for one.

But to get these benefits, you must take on the risk of owning the stock. And it is a risk. After all, stocks can drop in value.

The Third Law of Averting Ruin

Don't Fight the Wave

Again and again, we see that the market systematically transfers wealth to those that are willing to take on risk, at the expense of those who are not.

You may feel like you want to be on the wrong side of this current. But avoiding the risky bets means forgoing (or paying) the risk premium.

The right side is uncomfortable.

Be willing to endure some risk and DON'T PANIC.

That doesn't mean you can never take the other side. You can, tactically, or to limit your own risks, because we Don't Bet the Farm. But your portfolio, as a whole, should be favored by the current. You will wipe out sometimes. But if you follow the Laws, you won't be ruined. Surf the wave. Trade with the wind at your back.

Be the insurance company, even if you have to buy some reinsurance. Be the bank, even if you also borrow money for leverage.

You are allowed to be bearish at times, but it's better to sell calls or buy anticorrelated bonds and continue to collect the risk premium, than to short the stocks and be on the hook for the dividends or buyouts.

Buy-and-Hold works, folks! It can work against you too. Sell the option. Buy the stock. Carry the currency. Collect the premium.

Market Misconceptions is up next.

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