The first law of thermodynamics and investing risk

Don’t hold your breath waiting for a perpetual motion machine. According to the first law of thermodynamics, energy cannot be created or destroyed, only transformed from one form to another.1

Many have claimed over the centuries they can beat the law of the conservation of energy.

But today’s physicists scoff. We’re wedded to the laws of thermodynamics and the principles of entropy.

A schoolchild could see the flaws in the first perpetual motion machines, but even modern theoretical ones have been debunked.

There are always energy inputs and outputs the inventor overlooked.

Risks, rewards, rows, and rip-offs

I see parallels with investing, and especially with risk.

Whenever a row flares up about the merits of some particular asset class, often someone is really just expressing a preference for one type of risk over another.

Often the most vocal are only revealing what they don’t know, or at least under-appreciate. But at their worst, they’re as misleading as a batty inventor hawking Newton’s cradle as the solution to clean energy.

Financial firms exploit the confusion, too, for example by peddling structured products. They’ll sell you a guaranteed equity bond – that isn’t a bond, and perhaps isn’t even guaranteed.

The most complicated ones mix several indices or stocks to produce something so opaque you might as well buy magic beans. They also introduce counterparty risk, since they’re based on derivatives backed by investment banks.

Even professionals struggle to evaluate the risks. What hope do we have?

I’ve explained how to construct a DIY version of such a bond if you’re curious2.

The point though is that structured products are risk transformation machines. They are marketed as reducing risk (“guaranteed!” “bond!”), but in reality they swap one risk for another – including the risk that a lot of your returns are going to end up in the provider’s back pocket!

The law of investing risk

For fun, we might write the first law for investing to state:

“Investing risk cannot be created or destroyed. It can only be transformed from one form of risk to another.”

Note I don’t mean this to be literally true. For a start, diversification provides a ‘free lunch’ that does reduce risk.

I’m also not saying some investments can’t be riskier then others.

True, we can’t really quantify risk (which is why academics turn it into volatility, which we can) so it’s hard to say whether, for example, swapping blue-chip shares for growth stocks is riskier for a particular individual. Especially as it’s impossible to divine the future, or even to value the market – let alone consider a parallel universe where things played out differently.

The chances you’ll do worse holding growth shares might be much higher than if you’d invested into an index fund, but the returns if they do well could be greater. Academic studies show value shares have usually beaten growth shares, but they might not for you.

And that’s critical. We never truly know the odds.

You might say, “Well, I’d rather have the surer returns from an index fund to the uncertain returns from a bunch of small cap stocks” and that’s sensible.

But understand you have given something up – the “risk” of doing better from the riskier offering.

Nobody knows

Another example: Try suggesting it’s okay for some people to hold a slug of government bonds.

Then duck.

Critics don’t like the idea of holding bonds, because they see them as priced for a certain fall3. Bonds have been through a 30-year bull market, and the yields are very low. It seems likely that yields will go up, depressing prices. That makes bonds riskier in their view.4

If you think a 0.25% real return on a ten-year bond is not worth the risk that inflation will be higher and your return negative, you may choose to sell your bonds.

But risk has not been eliminated. It has merely been transformed.

If you go 100% into shares, you swap the seemingly high risk of low returns from bonds for the possibility of doing much better, but also the chance that some years your share portfolio may fall 40%. That’s unlikely to happen with bonds.

Similarly, some people say “deflation is dead” and that you should only own hard assets, such as shares, property, or gold. No bonds or cash.

They might be right or wrong. We don’t know that they will or won’t be. We can’t invest in counterfactuals, only the reality that unfolds over time, and this uncertainty means most of us should spread our bets by spreading our risks.

A Japanese investor in 1989 might have thought deflation was dead. Yet that’s what she got for 20 years.

You think a low return from bonds is much likelier than deflation? So do I. But you’re taking on new risks if you swap all your bonds for equities.

Risk transformers: Dangers in disguise

I could go on – and if you were at the worst dinner party of your nightmares, perhaps I would.

So let’s end with a few more examples of the transformation of risk:

• You want excellent returns ASAP, so you put all your money into momentum stocks. For a while you outperform, then the market tanks.

• Dismayed, you switch to a diversified portfolio. Volatility is reduced, and sure enough your portfolio returns 6-10% a year. However after three years you calculate you would have doubled your money if you’d stuck with your beaten up growth shares.

• You decide you have zero risk tolerance, so you only save in cash. The cost of peace of mind is the risk of not having enough money to retire on because the returns from cash are so low.

• To boost your returns, you lock your cash away for five years at a slightly higher interest rate. But have you remembered the time value of money?

• You want an income in retirement so you buy dividend-paying stocks. You get a rising income. However you overpaid for your shares during a period of dividend mania, and your portfolio’s value lags the index. (You don’t mind? Great – it was the right transformation for you.)

• You’re a fund manager who will be fired if you fall behind your peers. So you mimic the index, swapping career risk for the risk of short-changing your clients.

• You hate the UK economy so put all your money in Japan. It does well, but you forgot about currency risk. Your returns are halved. (Or maybe doubled!)

• You don’t like owning property shares so you invest in a buy-to-let. You’ve swapped stock market volatility for concentration risk, as well as the risk of having less free time. (You’re hit in year two with a bill to replace the roof, or you take a tenant to court.)

• You think shares are too risky so you give your money to a manager who mysteriously returns 10% every year. Oops, he was Bernie Madoff!

• You and your Nobel Prize winning buddies make steady returns whatever the market through arbitrage. You’ve swapped short-term volatility for modest but positive returns, as well as the risk of catastrophic failure – but you don’t realise that, because it’s not in your model. Catastrophe occurs, and your fund, LTCM, goes bust.

The list is endless.

At your own risk

I’m not saying there’s no case for making judgments about what risks are right for you, or even that some kinds of risks aren’t better compensated than others – such as the return premiums that have stood the test of time.

Also, my First Law of Investing Risk is for fun, not meant as a genuine principle of finance. (My real first law is every investment can fail you.)

The takeaway is an old one: If something looks to good to be true, it probably is. Look for the hidden risk!

Now, where did I put my electromagnets? I’m bored of these soaring energy bills, and I have an incredible gadget in the cellar…

1. Note to the scientifically minded: This is a bird’s eye view for the purposes of an investing metaphor. Unlike a hypothetical ‘isolated system’, a blog article is not perfect or complete. [↩]
2. It’s harder now with low interest rates. [↩]
3. I happen to think bonds are likely to do poorly from here, too. But that’s not the whole picture. [↩]
4. Some have even called them riskier than equities, which in my opinion is misinformation of the ‘not knowing what you don’t know’ variety. [↩]