When Everything Goes Wrong (Or Why Some People Will Never Get Rich)

When everything goes wrong

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.

Work hard. Save money. Bank a bonus or two.

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.

Net Worth Evolution

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!”

or simply:

“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.

Inflation

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!

About Banker On FIRE

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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker.  I am passionate about capital markets, behavioural economics, financial independence and living the best life possible.

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28 Comments

  1. Excellent article today. A really important area, which like a lot of things financial, needs to be taught at school!

    • Thanks Alan.

      Mention risk management and most people’s eyes will glaze over instantly. But being able to appropriately assess and manage one’s risk exposure is probably one of the top skills an investor should work on.

    • It’s a meaty subject, and perhaps not as easily digestible in a blog post.

      That being said, let me think it over and perhaps I’ll come up with something.

      Thanks for the suggestion!

    • Indeed.

      Unless one is happy with the status quo (and it incorporates proper downside protection from inflation), it’s best to get a move on!

  2. Ha – well, you know I’m going to have enjoyed this one 😉

    Absoluely agree – risk/reward are two sides of the same coin but the number of people who don’t see it like that never fails to surprise me. Boh in life and in finances. There’s just no such thing as risk-free.

    What makes the difference to success though I think is knowingly choosing which risks you want to take and how you plan on managing them. Fwiw, something you do pretty well & it’s nice to see.

    • Glad you caught the anonymous shout-out!

      Perhaps it’s a function of being in banking, but I view most things through the risk-reward prism. I guess that’s a side benefit of wearing the finance hat for so long! 🙂

  3. Thanks for the post – though provoking. Out of interest do you ever use things like Kelly Criterion to define your asset allocation? I try and use the general basis for this but have found that the size of the ‘winning ‘ investments seems to skew the results somewhat ….

    • Cheers Drecsel.

      To be honest, I don’t do anything too complex.

      My desired asset allocation is about 40% equities, 40% real estate, 20% cash.

      In equities, I go for a simple S&P 500 tracker fund + some small cap and value index funds.

      Real estate is a bit trickier – I try to diversify across types of properties but all of my holdings are in or around a single metropolitan area so there’s some concentration risk there.

      It’s not 100% scientific, but it’s good enough to ensure sufficient downside protection, barring a catastrophic event of some sort.

  4. Good read. As you point out there is still a degree of risk in holding assets that we consider safe, particularly if they underperform the rate of inflation.

    Formula for SD in a two asset portfolio is:
    SD^2 = (w_1)^2*(σ_1)^2 + (w_2)^2*(σ_2)2 + 2 * w1 * w2 * p_(1,2)*σ_1*σ_1

    Is it not? Although I can see the added layers of complexity that could come about from holding more than 2 assets.

    • It is, but that formula just made my eyes glaze over 🙂 – and that’s coming from a finance professional.

      I think the higher-level point here is that one needs to:
      – avoid viewing risk as an “all or nothing” proposition
      – find a place on the risk-reward spectrum they are comfortable with (acknowledging the status quo also carries risks)
      – most importantly, avoid holding investments that carry a risk of seeing the entire principal wiped out

      Otherwise, risk falls into the “too hard” category for most people, and they either end up not investing, or not investing appropriately, both of which are very dangerous.

    • I think there may be a typo in your formula; specifically in the covariance part.
      Should the last term include a “_2” rather than “_1”?

      • Right you are.

        Never really thought about it before but how do you think the calculate the beta on an index? Run the above but with say 2500 figures?

  5. Hi BOF,

    A question of comparison between stock investing vs real estate investing.
    On many fronts, stocks seem to outperform real estate. Its historic total returns are higher, the ability to diversify is also better (it’s near impossible to invest in a global real estate portfolio); however, real estate has 1 important element that makes it better than stocks: leverage.

    Conventionally, real estate investing comes with 4 times leverage (25% deposit and 75% LTV mortgage), which can multiply a return on investment from 5% to 20% which will beat any globally diversified stock portfolio by a long shot.

    This makes me wonder, why don’t I just use the same amount of leverage with stock investing? Just open a CFD account and buy stocks with 4x leverage. There will be overnight fees but I have taken a look at Etoro and calculated its overnight fees for S&P 500 index to be around 2.5% – 3% a year interest, which is a very reasonable rate, similar to many mortgage interest rate. I will be entitled to dividends from the CFD holdings too.

    So far, I have identified 1 biggest risk with this: stock market has higher volatility. It crashes 40% more often than we like. But I could hedge against that risk by reducing leverage, using just 3x instead of 4.

    My question is, what else am I missing? why aren’t more people doing it already?

    Thanks a lot

    • @AaronTran

      Think the only bit I’d say is you run the risk of margin calls with volatility where Etoro may close out your open positions if you don’t have enough cash / collateral to cover the call.

      Say you have $50 of equity, and in your example at 3x leverage, you have $150 of margin loan (so 25% equity in your example), and you buy $200 of shares in total

      Say security value drops by 12.5% in a day, therefore your security is now worth $175.

      (Security value – margin loan) / (security value ) = ($175 – $150) / $175 = 14% equity value from 25% equity. Etoro depending on their minimum margin requirement would then force sell your security to the extent you don’t have enough cash as collateral. to whatever their minimum margin requirement is.

      Say minimum margin requirement is 20%

      Amount to Meet Minimum Maintenance Margin = (Market Value of Securities x Maintenance Margin) – Investor’s Equity = $175 x 20% – $25 = $10 of cash or additional collateral you’d need to post to not have your positions closed out. Depending on the broker if you don’t have that cash available for them to draw on, they’d just close your open positions.

      @BoF
      Great article as always, and great following your journey on investing. I’m slowly moving more cash into low cost trackers to reduce cash allocation, and make sure I don’t have too many eggs in the property basket myself…

      • Thanks a lot for that explanation
        “$175 x 20% – $25 = $10 of cash or additional collateral you’d need to post to not have your positions closed out”

        -I totally understand that risk, which is why I mentioned having a chunk of cash on the side to cover any margin call. If you think about real estate investing, it would be exactly the same. For example, tenants smash the properties, or refusing to pay rent etc, these are all the risks that landlords have to deal with and need a healthy amount of cash buffer to pay mortgage during tough times to avoid repossession.

        -I do acknowledge that a stock market crash can crash more heavily (circa 40%) than housing market crash (circa 20%). But by reducing leverage with my CFD, maybe just 2x instead of 3 or 4, I can still multiply return on investment to more closely match that of real estate investing with a similar risk level.

        -Is there still something else I am missing in my approach to (slightly) leveraged stock investing?

    • @Aaron – I think KoF’s explanation is spot on.

      Unlike with equities, banks don’t ask you to top up your mortgage every time your property declines in value.

      And while you certainly need proper liquidity to sustain any near-term issues like vacancy, the amount of that liquidity is far lower vs the value of the property. For example, a $1m property with a 6% cap rate requires “just” a $60k buffer to replace a years’ worth of net operating income.

      Is $60k a lot of money? Sure, but it’s only 6% of the total property value.

      The other point is that if you are buying stocks on margin but keeping a significant cash cushion on the side, you are not really levering up, are you?

      Might as well put all the money to work and avoid paying the interest on the margin.

      Hope that makes sense!

      @KoF – glad you enjoyed it! I’m going to scale up our property exposure to about 40% or so of overall portfolio (which means buying another property over the next 12 months) and then stick to 40% property, 40% equities, 20% cash allocation.

          • 40% in terms of equity in the property.

            It excludes primary residence given that we rent at the moment, which is unusual given our overall property holdings but makes sense for us given our near term plans.

            When we do buy our dream home (likely in 2-3 years), I will include it in the net worth number and our overall real estate exposure.

  6. Great points! If you were going to force me to give a max downside to my portfolio, what might be the thought process for working through that math? Stocks, real estate, bonds, cash. Hmm.

    • Thanks DR!

      Rule of thumb could be:

      Stocks – down 50%, with anywhere from 6 months to 3-4 years until full recovery (you’ve got to make sure you continue buying when they drop, that’s where the money is made)

      Real estate – possibly down 20% – 30%. However, it doesn’t really matter as long as you are able to hold on to your properties by continuing to make your payments.

      Bonds – tricky one. Will likely wobble in a severe crash scenario but otherwise will hold value or even increase in value in a crisis (flight to quality)

      Cash – obviously king in a crash, money-losing proposition (inflation) in all other scenarios!

      Most importantly, don’t forget to think through what the impact on your job and earnings could be

  7. Banker on Fire

    Is there any reason you use S&P 500 for your equities as opposed to a global and/or FTSE All-Share ETF.

    Do you use the S&P 500 hedged to GBP or unhedged.

    Are your small caps and value ETFs in America or global.

    Thanks

  8. How do people find out if any assets become overvalued. For example if the S&P 500 is overvalued is it best not to invest or too sell.

    • Metro,

      It’s a tough one to address in a comment.

      My suggestion would be to read the book below which should give you a good steer on the best possible investing strategy – and answer the question above in detail:

      The Simple Path To Wealth by JL Collins

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