Our journey to wealth started in earnest about ten years ago.
My wife and I had just moved to London. In our late 20s / early 30s respectively, we were about to embark on the next leg of our professional careers – and were determined to make the most of it.
The first five or six years were anything but eventful.
Use that money to pay off my six-figure student loan – and invest whatever was left over.
Then, put our noses back to the grindstone and do it all over again.
We used whatever free time was left over to enjoy life, do as much traveling as possible, and spend time with friends.
Updating our net worth file on a monthly basis was not part of the routine.
Things finally got more exciting on the personal finance front about six years in.
During one of those infrequent net worth updates, I realized we had cleared the one million mark.
By this point in time, three things had been working in our favour:
- Our earnings had gone up meaningfully, a function of hard work – and simply staying in the game for as long as we could
- Our stock market portfolio reached the kind of critical mass where compounding actually becomes noticeable
- Most importantly, we’ve built up enough equity in our real estate investments to be able to take some money off the table – and use it to buy more properties
Now, it’s easy to keep the first two aspects incognito. You just need to keep your paystubs (and your brokerage login details) to yourself.
Not so much with real estate. While we certainly didn’t publicize it, our property buying spree had not gone unnoticed amongst family and friends.
More than a couple have reached out for advice – and we’ve done our best to help.
It was these conversations that made me realize why some people are pretty much guaranteed to become wealthy with time – while for many others, it will remain nothing but a dream.
The simple answer lies in their approach to risk.
In today’s post, let’s go over what risk really is, and the right way to think about it.
A Conceptual Matter
“What if I lose my money?”
“This sounds like a lottery!”
“That’s pretty risky, isn’t it?”
When you hear statements like these, you know that people don’t understand what the word “risk” actually means.
Here is the textbook definition:
Risk is a degree of uncertainty and potential financial loss inherent in an investment decision.
There are two distinct, but related components here.
The first one is the probability that an adverse event will actually occur.
The second one is the potential loss that will transpire as a function of that adverse event occurring.
Both add up to the degree of risk you will actually take on when making an investment.
With that in mind, below are some simple risk facts to keep in mind when evaluating investment opportunities.
Risk Fact #1: Most Assets Are Risky
That’s right. There’s a reason they call them risk assets in the first place.
Equities are risky. A nasty accident can send your BP stock plummeting like Icarus.
And as Mr. Bill Hwang (and more than a few of his bankers) have found out over the past few weeks, levered equity investments are even riskier.
Other asset classes, like triple-A rated corporate bonds are less risky.
And notwithstanding what some people will tell you, even US Treasuries are also not risk-free.
Yes, you will always get your principal and interest back. But you run the risk of the purchasing power of the dollar declining in the meantime, which reduces your real returns.
Let’s not get into semantics though. Investing in US Treasuries is not the same as buying Tesla on margin – because:
Risk Fact #2: Risk Is NOT Binary
I can’t say this enough.
Treating risk as a binary event (i.e. “if X happens, I lose all of my money”) is the biggest mental obstacle to investing.
Yes, depending on the investments you make, there is a chance that you will lose all your money.
Referring back to the textbook definition above, there is a non-zero probability that the potential loss you will incur will equal 100%.
But let’s double-click on that.
In the stock market, it would probably take a full-scale nuclear conflict to erase the value of a well-diversified world tracker portfolio.
If you are invested in corporate bonds and the issuer goes bust, you will likely lose some money.
But having a senior claim on the assets means that despite the haircut, you will likely walk away with some of your principal.
In real estate, you can lose money if you default on your mortgage payments and the property is repossessed.
However, having a large enough cash balance (and a diversified enough tenant base) allows you to ride out the rough times.
So once again, losing all of your money is an unlikely proposition.
That being said, there’s a big difference between a $12m S&P 500 portfolio and one consisting entirely of Tesla shares.
Just like the difference between a cash-flow negative, 95% levered residential property with no cash buffer and a solid yet boring investment with healthy cash flows and a 40% equity cushion.
Which conveniently brings us to the next point:
Risk Fact #3: You Need To Measure Risk
But… most people don’t.
The vast majority of individual investors I have met (barring one very smart reader of this blog) don’t even know how to measure the risk profile (i.e., the standard deviation) of their portfolios.
By the way, I don’t either – but us passive investors can simply look at the S&P 500 as a proxy.
In real estate, however, it’s much easier to do – and yet people often don’t take the time to deconstruct their returns.
Was it the nice and predictable cash yield that drove the returns?
Was it the equally predictable de-leveraging?
Or was it the good old price appreciation that saved the day after a long stretch of stagnating prices?
As a result, people often attribute success to luck and not skill (and vice versa).
You often hear things like:
“Bob got really lucky with that investment.”
Is that right?
Or could it possibly be that Bob evaluated a number of opportunities, ran the numbers on all of them, and picked the one with the most favourable risk-return profile possible?
Perhaps that also explains why Bob seems to have been getting lucky for 20+ years?
Alternatively, it’s statements like:
“Sandy is a great investor. She’s made so much money over the past few years.”
Perhaps she is.
Alternatively, she could be benefitting from a rising tide that lifts all boats.
In other words, everyone is a genius in the bull market.
Risk Fact #4: The Status Quo Is Just As Risky
This might well qualify as the most frustrating part of the attitudes towards risk.
For some reason, most people treat their current situation as some kind of a perfect setup.
“I’ve got $10k saved up, and I’d like to put it to work – but I don’t want to lose it.”
In other words, things are great. If there’s upside, I’ll take it – but there better be no downside.
The problem is, of course, that the current situation has “downside” written all over it.
It’s a bit like a melting ice cube.
You can’t quite put your finger on it, but it keeps getting smaller and smaller – and there’s nothing you can do about it.
You can (and should) worry about the risk profile of the investments you are making. Today’s post can act as a mental model to help do just that.
However, don’t forget about the risk profile of not investing in the first place.
Otherwise, you’ll never get rich – it’s as simple as that.
Good luck – and thank you for reading!