Thursday, March 5, 2015

What Icarus Can Teach You About “Return-Free Risk”

Brad Christensen
Yellowstone Partners Wealth Management

Most of us know the story of Icarus, the Greek mythological figure who flew too close to the Sun. But do you know the whole story?

Together with his father, Daedalus, Icarus was imprisoned in the labyrinth by King Minos of Crete. Unwilling to submit to captivity, Daedalus gathered feathers and wax and made wings for himself and for his son.

As they prepared to escape, he offered Icarus two points of advice. His first caution was the one we all know, “Do not fly too high, for the heat of the sun will melt the wax and leave you wingless.” But the second, which time seems to have forgotten, was this: “Do not fly too low, for the waves of the ocean will overtake you.”

Icarus soared too high and felt the heat of the sun remove his wings before plunging to his death. If he had flown too low, perhaps we’d more easily recall the second warning, but that’s not how it happened.

In conversations with clients almost every day, I often discuss the balance between risk and reward – between flying too high and flying too low. Every investor wrestles with risk and return. It’s immensely frustrating that return only comes to those who expose themselves to risk, and it doesn’t seem greedy to desire a solid return on investment without the potential to lose, but in today’s low interest-rate environment this is reality.

With yields on CDs, money-market funds, and bonds near historic lows, we’ve entered into a time when cash-equivalent assets suffer from the same type of danger Icarus would have been exposed to had he flown too low. Warren Buffett, one of the world’s great investors, has dubbed it “return-free risk.”

In a February 2012 article for Fortune magazine, Buffett detailed his investment philosophy, specifically, why he prefers stocks over gold and bonds for the long-term. In it, he divides the universe of investment opportunities into three separate classes.

1. Currency-denominated assets (bonds, CDs, money market funds). These are common investment instruments and are commonly denoted as “secure.” Some subsets of this class have historically been described as offering “risk-free return.”

2. Non-productive assets (oil, precious metals). Investors generally accumulate these assets on the premise that they are undervalued relative to an unknown future value. The principal problem with this class is that there is no mechanism for these investments to procreate.  Derivation of gain will come only from supply/demand re-pricing.

3. Productive assets (farms, businesses, real estate). Whether owned in the public market or in private, productive assets are generally capable of yielding annual return which may be reinvested or returned to owners.

Even from their definitions the productive asset category has a clear advantage over the others in the sense those assets are procreative. Consider the farm example, which may be capable of producing a variety of crops each year while still maintaining an intrinsic value of the land, which may fluctuate based on supply and demand.

Buffett is high on productive assets for good reason, as is demonstrated by the graphic below, an asset category historical return “quilt” that plots return statistics for each category over the past 20 years.  Even from a glance at the averages, it’s clear to see that the return profile favors the third class.

The four boxes mopping up the bottom of the list hail from the currency-denominated and non-productive categories. While these investments have their place in short-term investing, when it comes to an extended time-frame, this is precisely when the notion of “risk-free return” flips to the more accurate depiction of “return-free risk.”

When it comes to selecting an overall investment allocation, emotional schools of thought vary, from purchasing the previous year’s top loser (in hopes of a drastic recovery) to purchasing the previous year’s top performer (in hopes of a repeat performance).

Yet, a more rational approach is to build a diversified portfolio – consisting of productive assets such as small/mid/large cap stocks and real estate investment trusts (REITs), which will ultimately provide strong performance balanced with some of the other categories to reduce exposure to the extremes and safely navigate a solid return.

Precisely what Daedalus advised his son.
Click on the chart for a more detailed look at it and click here for even more information.