In your mind, which investment represents the greater risk right now? Buying a 10-year U.S. Treasury bond or a Europe-only stock fund?
The 10-year Treasury bond had an income yield of 1.6 percent at the end of August. In a world where inflation is likely to never dip below 2 percent – and could easily double that – the Treasury bond is essentially guaranteed to lose purchasing power. If interest rates rise, it may not even protect its principal value. It could have a negative total return over its 10-year life despite its perception as a safe haven. Realistically, the only reason to buy the Treasury bond is as insurance for your stock investments. If you think there is significant likelihood that stocks will perform poorly, then the Treasury bond has merit for its potential protection of money needed in the short term.
While I don’t think it’s prudent to steer a lot of money into a Europe-only investment, the contrast here is to demonstrate that the perception of risk for many people is flawed. An investment such as the Vanguard MSCI Europe exchange-traded fund (VGK) may be a better investment over time even on a risk-adjusted basis compared with the Treasury bond. The Europe ETF has a current price/earnings ratio under 10.5, more than 30 percent below the 20-year average. It is historically cheap. As a function of the declining price, the dividend yield of the ETF over the past 12 months is 4.45 percent.
Even with no growth in the price of the investment, the dividend easily outpaces inflation creating a real return and the opportunity to compound growth.
Conservative investors or those with short time horizons shouldn’t shift money from Treasury bonds to European stocks but it should be clear that the perception of which is riskier over the long-term is not always intuitive.
Here’s another variation on the theme. Which investment carries more risk: an emerging markets bond fund or Apple stock?
Apple has had a tremendous run. Its stock market value is the largest in history and already 50 percent larger than Exxon, which it passed as the most valuable company in the world only a year ago. Apple stock is worth 12 Boeings. It could be that momentum will carry Apple even further. But each investment in Apple that comes at a higher price makes the purchase more risky.
Let’s say that you invested in Apple stock at $405 per share at the beginning of 2012. The investment would have grown 65 percent through the end of August. However, if you bought Apple stock now and you expected the same results, the stock price would need to reach nearly $1,100 per share. While the new investor might be thrilled with the subsequent 65 percent gain, the person who entered at $405 per share would have a 170+ percent gain, a much bigger return and much less risk of loss. The higher the price goes, the bigger the losses will be suffered by those who enter at or near the peak. Apple may continue to innovate its current products and take over different industries, like cable TV, but buying in now represents an entry point with elevated risk.
On the other hand, many people would consider an investment in government bonds of emerging nations to be more risky than jumping on the Apple bandwagon. The “emerging” label generates fear that the investment may not be stable. That fear is overdone. Credit ratings have steadily risen from junk status to the low end of the investment-grade scale for many emerging markets countries (i.e., Brazil, China, Korea, Indonesia, Mexico). Many of these have government balance sheets that are healthy and debt loads that are minimal compared to the developed world. The likelihood of emerging markets bonds experiencing suddenly high default rates, especially defaults any more widespread than developed market countries, is not tremendously high. And these bonds payout significantly more income than their U.S. equivalents.
The point here is that your portfolio is likely missing investments that could be strong contributors to future returns and it is likely also holding investments that carry much more risk than perceived. Your riskiest investment could very well be the one that has done the best for you over time.
Most investors spend their time looking for the next great opportunity, usually jumping on the trend after the early investors in that opportunity have already made the easy money.
An important consideration is to look instead for the next great risk. Managing your investments to better navigate risk will ultimately be a more valuable exercise than trying to repeatedly identify high fliers with long-lasting momentum.Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones in Old Town Tacoma. Reach him at firstname.lastname@example.org or read his blog at themoneyarchitects.com.