People talk about risk in broad generalities, like, “that seems like a risky investment.” For example, if I said, “investing in land deals, managed by an experienced and capable team may be less risky than a FDIC -insured bank account [1],” your eyes might roll. So let’s dig a bit deeper.
As I write this, the “core inflation rate” is 6.50%, and the “inflation rate” is 8.50%. Wondering what the difference is? “Core” excludes food and fuel from the calculation – because after all, who needs those items? Well actually, I suspect it is because it allows headline discussions of inflation to show a lower number.
From a finance perspective, you can get a view of what people think inflation will be in the future by looking at the “breakeven” rate between 5-year TIPS and 5-year Treasuries. TIPS are US Treasury notes that have built-in inflation protection. The breakeven rate is just the difference in yield between the inflation protected and nominal debt. Today, that’s 3.27%. One year ago it was 2.44%. And today’s 5-year Treasuries pay 2.84%; last year it was 0.83%.
What’s this have to do with risk? If you keep all your cash in the bank, the principal is safe. But your purchasing power is declining with inflation. Depending on your perspective, declining at 8.5%, 6.5%, or 3.27% projected out five years. So there is a risk: “hey, put your money in my bank and I’ll reduce its value by 3% to 8% over the next five years!”
Another way to consider risk is volatility. The S&P 500, for example, has a standard deviation on price that averages, over the long term, at around 15%. Over the past five years, it was 15.73%, and over the past three years, 17.71%. There’s even an index, VIX, specifically to look at this volatility. It uses current options prices to infer how investors perceive volatility for the next 30 days.
As a rule of thumb, when the VIX is below 20, things are stable and stress free. When it is above 30, it usually indicates a period of uncertainty, risk, and investor fear. Today’s VIX is 33.52.
Pretend you’re an investor deciding what to do with some excess cash over the coming three to five years. If you keep it in the bank, you’ll explicitly lose money at the inflation rate (or actual core inflation rate, which is worse). But, you won’t lose any of the principal.
If you add money to your stock market holdings, you might make an assumption about future returns. Let’s posit that the S&P 500 today, given its CAPE ratio, inflation risk, and pricing, might return 6% annually for the next five years. So what’s the risk? In the simplest terms, if inflation is accurately predicted by the breakeven rate at 3.27%, then your actual return will be 2.73%. With quite a bit of volatility. Yikes.
Speaking of volatility, we can use a coefficient of variation to quantify this so that we’ll have numbers to compare. Consider the dispersion of the asset’s potential excess returns relative to the expected returns, which is to say, divide the standard deviation by the expected excess return (aka, get a coefficient of variation). In this example, you have 20/(6.00 – 3.27) = 7.32. And now we have a number to use for comparisons.
What if you place the excess cash into a trusted real estate investment fund, where the anticipated return might be 20%. In the simplest of terms, 20% minus the 3.27% breakeven rate is 16.73% which feels pretty good. As far as that comparison number goes – let’s arbitrarily say the volatility of real estate is 10% (probably it is much lower today). The numeric value here is 10/(20.00-3.27) = 0.6. Which also feels less risky.
Now there are other aspects to risk, such as liquidity. Bank accounts have great liquidity. Stock investments do as well, but are more subject to volatility (you might have to take a 20% loss on your withdrawal one day, but eight months maybe you’d have made 8% instead). Land investments are highly illiquid – you’re tied up until the project completes.
Comparing investment risk is essential to gain a full understanding of your alternatives.
[1] As our attorneys point out, there are substantial risks in real estate investing, and they and the SEC want to make sure that we remind readers of this at every opportunity. So be sure to read offering memoranda and associated materials, and even consult knowledgeable and trusted experts, before you decide to invest money in any private placement opportunity.
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