Individual investments in our portfolios may be viewed as “bundle” of different risks: term risk, default risk, equity risk, alpha risk, illiquidity risk, and leverage risk. Some investments—such as the 30-Year U.S. Treasury Bond—carry only a single type of risk (term risk), while more complex investments or fund vehicles such as venture capital funds may embed multiple types of risk (term, equity, alpha, illiquidity).
Each of these types of risks commands a risk premium—an extra bit of expected return in compensation for the added uncertainty that each type of risk brings. Risk premiums rise and fall over time based on market valuations, the amount of systemwide liquidity available, the level of economic growth and innovation, and the mood or sentiment of investors. Prudent investors often compare the current expected risk premium for a particular type of risk with its historical average to determine whether that added risk is attractive or not, though in the current environment we note that some historical averages no longer seem universally relevant to investors.
Investors applying the goals-based framework understand the specific characteristics of different personal goals suggest that certain types of risk are or are not appropriate. For example, investors whose goals are heavily front-loaded in their time horizon (e.g., years 1-5) will find the risk premium for illiquid investments rarely compensates adequately for the inability to turn the investment back into cash within that time premium; conversely, a multi-generational trust might consciously seek out such a risk and judge the risk premium offered highly acceptable.
Understanding the types of risk available to investors and matching those appropriately to the characteristics of one’s goals is the key to success.
- Speaker: Jack Parham – Chief Investment Advisor, Eton Advisors Group
- Host: Greg Dixon – Marketing Consultant, Eton Advisors Group