Don’t Get Fleeced by Taking on Uncompensated Risk

This is a guest post by The Biglaw Investor.

We all know that risk equals reward. Nothing ventured, nothing gained, right?

When it comes to investing, it’s easy to see the superficial relationship between risk and reward. The vast majority of investors think loaning money to the federal government is a sure bet. The result? The 10-year Treasury is currently hovering at 1.5%.

Want to take on a little more risk? Invest in New York City municipal bonds through Vanguard and you’ll take on the risk of an NYC bankruptcy.

Finally, there are stocks for investors willing to stomach the most risk. Again, we can superficially make sense of this relationship by thinking of the price of these assets as a function of supply and demand.

The demand for stocks is less than the demand for treasury bonds. How do we know this? Because all things being equal, investors would prefer to be backed by the full faith and credit of the United States government with a tax raising arm that can raise trillions of dollars in revenue. That drives down the return on Treasuries to the point that some investors willing to take on more risk consider investing in stocks.

Now, take a second to think about it. Would you take on more risk if you weren’t compensated for that risk?

Seems silly, right? Who would invest in stocks and deal with the volatility of the return on stocks was the same as you could get on a 10-year Treasury note.

Yet investors take on uncompensated risk all the time.

Let’s talk about one example: imagine you have the choice of investing in one company (let’s say IBM) or investing in a broad based index fund that owns a slice of every company (let’s say Vanguard’s Total Stock Market Index).

Which is the riskier investment?

It’s obvious that owning IBM is a riskier proposition. You’re taking on (1) bankruptcy risk; (2) industry risk; (3) management risk; (4) accounting fraud risk and a host of other risks that could wipe out a company (remember Enron?).

And yet the market will not compensate you for this risk. You do not get paid more money for specifically investing in a single company than you would get by investing in a broad based index fund. There’s no mechanism to compensate you for the risk.

Why does uncompensated risk exist?

Because even though the risk is real the market knows that it’s easy to eliminate this risk. All you need to do is diversify your portfolio to eliminate it. Instead of owning one company, buy slices of

100 companies. Because the risk is easy to eliminate, the market will not compensate you for taking it.

Said another way, you can’t expect to receive anything extra from running across an intersection during a green light rather than waiting for crosswalk sign to tell you to go. The former is just a risk that you take. The latter is the reduction of that risk. The result (crossing the street) is the same either way.

If you’re taking on uncompensated risk, you should evaluate your portfolio to see if it can be eliminated.

In addition to diversification, another classic example of uncompensated risk comes in the form of active management of an investment. This risk is called “management risk”.

When you invest in an actively managed fund, you’ve taken on risk that you could be investing with the next Bernie Madoff. Is the risk significant? Hard to say. But it’s important to recognize that

you’re not being compensated for this risk. The market is not paying you a higher return specifically

because you’ve chosen to take on management risk as opposed to investing in a cap-weighted average of the total market.

Ultimately, it’s up to you as the investor to decide whether uncompensated risk is okay in your portfolio. As a lawyer, I’m generally risk averse in the first place and so I’m certainly not willing to take on uncompensated risk.

What do you think? Let us know if you’ve been tracking uncompensated risk in your portfolio.

The Biglaw Investor writes for lawyers and other high-income professionals. Curious about financial mistakes made by lawyers? You might be interested in the 11 Financial Mistakes Lawyers Make.

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