Well, there’s been enough bullshit written about risk to fertilize Kansas (with a little left over for western Iowa)! Here’s hoping my thoughts will help you build a structure, and not just make the fields a bit greener.

What Is Risk?

A partial (and the most pertinent for this book) definition of risk: Risk is letting short-term price fluctuations lead to decisions that cripple long-term investment returns. That’s the takeaway definition!

In terms of stock investing, however, risk is too complex to be defined in one statement or paragraph. One bullet can’t hit all the aspects of risk, so here’s a salvo.

Risk is discounting the effect of inflation when you’ve chosen a fixed income retirement portfolio

Risk is accepting the excuse that poor long-term portfolio performance is acceptable because “risk” was lower.

Risk is buying “penny stocks” in the hope they’ll go to a nickel.

Risk might be the “dirtiest word” in the investment dictionary.

Risk is basing any investment plan on anything less than decades or a lifetime.

Risk is using leverage or short selling stocks.

Risk is meandering and not taking a definitive investment route.

Risk is buying today’s “darlings” and not realizing that being “jilted” is inevitable.

Risk is buying individual stocks, hedge funds, commodities, private equity, and   except for a segment of the older population (those with very limited financial resources), fixed income assets.

Risk is being taken in by the canard that “sometimes Small-Cap Value (SCV) underperforms”. Just dial 1-800-Doctrine of Relative Importance and you’ll hear this: “MOST times Small-Cap Value outperforms”. Stay on the line for “thus far (10-12 years) Smart Beta SCVs have outperformed conventional cap-weighted SCVs”.

Underperformance is often referred to as “negative premium”. Remember, the reciprocal of “negative premium” is “positive premium”. So, if the Risk of a 5-year negative premium for a Small-Cap Value ETF investment is 20%, the chance of that investment having a 5-year positive premium is 80%. (I like those odds!). At 10 or 15 years, the chance of an SCV negative premium is miniscule, and, at 20 years, it’s virtually non-existent.

Risk is running out of money in retirement.

Risk is buying a stock on a tip from your brother-in-law or an overheard elevator conversation. (The elevator example is the only time you can be going for a ride and be “taken for a ride” at the same time.)

What’s the biggest Risk for most investors? Buying high and selling low! So, buy when you have dough, and never let go.

Risk is trying to pick individual Small Cap-Value stocks yourself. The mavens can’t do it, and if you’re like me, you’re a novice. Here’s a dirty little secret ─ I can’t name one company in any of my four Smart Beta Small-Cap Value Exchange Traded Funds – (SBSCV ETFs). Again, but not the last time: They are RWJ, EES, EZM, PRFZ. But, take heart ─ I know a hellova lot about stock classes and smart beta, and I’m modest, too.  And this isn’t just “pie–in–the sky”: I’ve reaped the rewards of Small-Cap Value investing for 17 years, and these ETFs for 12 years.

Risk is entering the stock market thinking it’s easy. Most newbie investors lose money in their early stock investing experience. Colonel Herman Hansen was the chief of anesthesia at the U.S. Army 97th General Hospital in Frankfurt, Germany when I operated there (1961 to 1963). Herman, who was a great physician and a great market teacher, referred to those losses as “the initiation fee”. The sad part: “active investors” never stop paying the fee.

Risk is taking your eye off the BIG PICTURE and being influenced by what you see on CNBC or read in the Wall Street Journal. Here’s a good example. Headline: “Active Managers Beat Indexes”. Why is it a headline? Simple ─ because it happens so damn rarely. I’m putting you on a straight highway to investing success. I can’t quantitate the degree of success ─ my crystal ball broke ─ but I’m certain detours will adversely affect your long-term results.

Most people who read this will notice it sounds more than a bit like “Grandpa’s Rules”. I plead guilty, and I’m pleading with the judge for a life sentence.

In the short-term, Risk is the possibility of losing money on an investment. Here’s how to handle the short-term ─ dismiss it. Have a rational lifetime investing plan and stick to it. Keep your investing eyes on the stars, not the clouds.

Ready for another Risk metaphor?  Risk is arranging your eye chart with RISK at the top in large letters, and reward at the bottom in mini-print.

Here’s a third, and thank God, last one. Listening to the risk-o-phobes, and missing the big investment picture is “tunnel vision.” Understanding that Risk is mitigated by time, and buying my SBSCV ETFs, is “ton-of-money vision”. Yes, you’re right ─ Risk is NOT following Grandpa’s Rules.

Comments by Others on Risk

It’s impossible to overemphasize the importance of the TIME-ELEMENT in Risk. Over periods of 10 or more years, the rewards of Small-Cap Value (SCV) or, in my case, Smart Beta (SB) SCV,  investing devour the slightly increased volatility of small-cap stocks. While many authorities have recognized that fact, it has always been as an afterthought ─ a throw-in ─ never the “main dish”.

There are two quotations I find particularly applicable to what I’m recommending. The first, by John Maynard Keynes, is “it is better for reputation to fail conventionally than to succeed unconventionally”. That could be the fate of my investment ideas: Although they are simple, safe, and historically productive, they may be, unfortunately, too far outside the conventional mainstream to attract a significant following. Those profiting from this strategy could be my family (they already have) and a few perceptive investors who are able to appreciate and apply “the Doctrine of Relative Importance” i.e. Grandpa’s Rule #2. (If I ever have to write “The Book of Delighted to Be Wrong”, that last sentence will be Chapter 1.)

John Bogle

John Bogle

John Bogle

My other guiding quote is from the late John Bogle, commenting on the arbitrary nature of weighing risk as equal to return. “An extra point of standard deviation is meaningless, but an extra point of return is priceless.” And the italics are his, not mine. Bravo, Bravo, Bravo! That captures my view of risk completely.

Unfortunately, after recovering the fumble (or making the interception or fielding the kick off) Bogle never runs with the ball. He never deviates from “broad diversification” in stocks (mainly large-cap) and bonds. His bond allocation ─ your age or your age minus 10% ─ makes me a very bad boy. (I get a zero in that class.) While on occasion noting the tax, trading, and fee advantages of ETFs, he still advocates mutual funds.

In “Don’t Count on It” (2011) Mr. Bogle recognized that ““small-cap stocks outperform large-cap stocks by almost two percentage points a year (from 1926 to 2002)”. (That premium is increased with small-cap VALUE and, thus far, further augmented by “SMART BETA”.)  He then dismisses this massive overall outperformance by saying “each and every comparison we see is period dependent.” I believe the entire 76 year record is what counts, and not the few periods when large cap stock performance was favorable.

At one point he says “It would not be unreasonable to hold 85% of S&P, 10% Value, 5% Small Cap”. But he never puts small-cap and value together, and the combination is like having Ruth and Gehrig. (I had an internet belly laugh when a friend emailed asking who “Ruth Gehrig” was.) He also expresses skepticism about small-cap and value outperformance lasting, ignoring what I see as a clear 90-year history showing their enduring superiority. (See charts 1,2, and 3.)

So, what’s the risk here? It’s having the ball and not running with it.

My Smart Beta Small-Cap Value ETFs have the best blockers. The field is wide open. The only thing you have to do is avoid stumbling.