Avoiding Risk Can Be a Very Risky Investment Strategy

Some investors tend to avoid risk when it comes to their investments.  They want returns without any risks, but avoiding all risk is the same as avoiding potential returns.  –Mark T. Hebner, businessman, investor, and author

The Parable of the Talents

I love the parables of Jesus from the New Testament.  One of my favorites is the “The Parable of the Talents,” found in Matthew 25: 14-30.

This parable tells the story of a master who travels on a lengthy trip into a far country.  While he is gone he entrusts his money to three of his servants.  To one servant he gives five talents, to another two talents, and to the third, one talent. 

According to Wikipedia, in Jesus’ time “A talent was a unit of weight of about 80 pounds, and when used for money, it was the value of that weight in silver.  As a unit of currency, it was worth about 6,000 denarii.  Since a denarius was the usual payment for a day’s labor, a talent was roughly the value of twenty years of work by an ordinary person.”  In today’s money one talent would probably be worth several hundred thousand dollars. 

When the master returns from his trip he calls his servants together to give an accounting of their stewardships.  The servant who had received five talents had invested them and doubled their value, returning to the master ten talents. 

Likewise, the servant who had received two talents had successfully invested them and returned to the master four talents.  Each of these servants received lavish praise and a great reward from the master. 

The servant who had received one talent was fearful of losing what he had been entrusted with, so he buried his talent in the ground.  His goal was to avoid risk.  When it was his turn to account he told the master what he had done and returned the original talent to him.  The master was angry with the third servant, calling him “wicked and slothful.”  His talent was taken from him and given to the servant with ten talents.

I realize that the parables in the New Testament have deeper spiritual meaning hidden behind their obvious interpretation, but the magic of the parables of Jesus is that they teach true principles on multiple levels.  The lesson from this parable, taken at face value, is that avoiding all risk in investing can lead to loss while taking wise risks can lead to great rewards. 

Applying the Lesson of the Talents to Modern Investing

In modern investing you can invest your money in stocks or “bury” it in savings accounts, CDs, and bonds.  Which strategy is riskier? 

There is no doubt that stocks are more volatile than bonds, making them riskier in the short-term.  William Bernstein calls this shallow risk.  You can usually recover from these losses in, at most, a few years.  The only way to turn this shallow, temporary risk into a permanent loss is if you sell out when the market is down, either because you panic or because you need the money. 

To compensate investors for the short term volatility of the market stocks have historically earned a return significantly higher than less volatile investments.  This is called the risk premium.   

As the time horizon increases the short-term volatility of stocks becomes less important and the risk premium more important.  In his book Stocks for the Long Run, Jeremy Siegel points out that, since 1802, stocks have outperformed bonds in 61% of all years, 69% of five-year periods, 80% of ten-year periods, 92% of twenty-year periods, and 99% of thirty-year periods.           

As stocks grow safer over longer time horizons, bonds and other “safe” investments become riskier.  Bernstein calls this deep risk, which he defines as a permanent loss of real capital.  Over a long time horizon bonds and other “safe” investments have much more deep risk than stocks. 

In the parable of the talents the servant who buried his money to protect it ended up losing it.  Likewise a “safe” long-term investment strategy can lead to significant loss.  The cause of the loss will not be someone taking away your money, as in the parable, but the steady, relentless, corrosive effect of inflation.   

Siegel reports that over periods of at least 17-years stocks have always managed to stay ahead of inflation, but bonds have sometimes suffered significant real losses over similar holding periods.    For the last several years money in savings accounts, most CDs, and many bonds has not kept pace with inflation.  This demonstrates the opposite of the risk premium, which Bernstein call the safety penalty. 

The Fourth Servant

When I consider the parable of the talents I find myself wishing there was a fourth servant in the story.  Like the first two servants this servant would invest the money entrusted to him.  However, either because of bad decisions, or just bad luck, he would not have doubled his money.  In fact, he might have even lost some of the original principal.

I find myself wondering how the master in the parable might have reacted to my hypothetical fourth servant.  In my mind the master would have been patient and understanding with him.  After all, the servant who buried his money was not condemned for failing, but for failing to try.  The fourth servant might have received some additional training, but I can’t imagine the master would have given up on him. 

This is all conjecture on my part, but what is certain is that if you do much investing some of your investments will lose money, especially in the short term.  How will you react when that happens?  Will you be patient and understanding with yourself, or will you give up?

Hiding from risk makes us feel safe, but it is actually leaves us very vulnerable.  History shows that embracing at least some short-term risk by investing in stocks is a much better long-term strategy.  How much risk you take is a discussion for another day.  For now it is enough to understand that the one of the riskiest investment strategies of all is to avoid all risk.