A great number of investors self-proclaim to have a conservative investment mindset. When you ask them what they mean by that – they say it means that they only make safe investments.
Some examples of assets that a conservative investor generally considers to be safe could be: 1) Prime real estate in international cities like London or Paris 2) Real estate with a “guaranteed” income 3) Sovereign government bonds 4) High-rated corporate bonds 5) Precious metals or 6) Shares in companies perceived to be safe.
Before we analyse whether the above assets are safe or not, we first have to understand what safe means for these investors. Does safe mean that the asset has zero risk? Does it mean that the asset has no volatility? Could it mean that it is impossible for the asset to lose value over the long-term?
None of the above. All of the assets mentioned above have risk, short-term volatility and even the possibility of depreciating in value over the long-term. Moreover, they generally offer modest, zero or even negative returns. Coupled with inflation eroding value further, a conservative investor could be steadily losing money over time even though he thinks he is not.
If safe assets have risk, why do investors call them safe?
No asset is perfectly safe. Some assets however have specific characteristics and attributes that make them on average safer than others. Therefore we have established that these assets are not absolutely safe, they are just safer than others.
Which begs the question; if these assets are just on average relatively safer than others (but still have risk), then what is the value of this relative added safety? Is the value infinite?
Clearly not, nothing has infinite value. And when investors treat assets as if they do, that’s when they start to run into problems. The problem with safe assets is that, especially in times of financial repression and zero interest rates like now, investors bid them up higher and higher – while touting the narrative that they are “safe” and that “you at least get a yield when bank deposits offer you nothing or even less than nothing”.
My point is that safety or lack thereof is not only a function of the type of asset that you are investing in – real estate, precious metals, private equity etc., it is also very much a function of the price that you are paying for that asset.
There are two determinants used to calculate with absolute financial precision the value of a financial asset and they are 1) the expected future cash flows the asset will generate over its lifetime and 2) the discount rate that will be used to discount those cash flows into the present. Let’s ignore the value of assets like precious metals and fine art for now because they have no cash flows.
There are however two problems when valuing an asset.
1) We don’t know the future cash flows and 2) we don’t know the proper discount rate. Therefore, value is not fixed and knowable but an uncertain and dynamic value that changes.
Let’s assume for a moment that we know the future cash flows that an asset will generate, but that we still don’t know the proper discount rate to use. Under normal circumstances, what investors generally do is choose a market interest rate that reflects their opportunity cost and a fair time value of money.
However, in times of extremely low interest rates investors engage in a desperate search for yield where they become forced buyers of assets that pay any yield because their alternative is even worse.
If their alternative is worse then why is this a bad thing?
For a given level of future cash flows, the value of the asset fluctuates greatly as a different discount rate is imputed into the calculation. The lower the discount rate the higher the value and vice versa.
When a forced buyer invests in an asset at a very low yield (i.e. the low discount rate), it means he is paying a very high price for the asset. In the short term, the investor achieves his stated objective – to make at least something. In the long term, the environment finally changes and the investment he made is now down in value significantly. The investor thought his capital was not at risk when he was making the safe investment, he was focusing on the yield (albeit small) he was going to earn. Finally the environment changes (e.g. rates go up) and he is losing serious money.
A conservative investor is not someone that buys conservative assets at any price. Doing that turns him into an aggressive investor – because the high price he paid for the asset relies on the future unfolding perfectly as priced in. To avoid any unwelcome surprises, focus on the price paid for a given level of value received.
Buying a safe asset at any price because it is considered “safe” is first-level thinking, and first-level thinking is easy. To excel in investing you need second-level thinking, and that’s not easy.
We can deduce from the above that a better definition of a conservative investor is someone who buys assets that are conservatively priced.
Continuing in the same train of thought, even assets that are traditionally considered to be risky can be part of a conservative investor’s portfolio. Equities, non-prime real estate or even oil tankers can be a conservative investment as long as the price paid for the asset is a fair one.
It is important to always balance two quantities when making an investment – price on the one hand and value on the other.
“Price is what you pay, value is what you get.”