Ep 86: What Are The Risk Factors that Matters to Retail Investors & How Do You Solve it?

Okay so by now you should have some core understanding of risk and also we probably have established this idea that for a lot of people, when they look at risks, it is very emotional, very qualitative. Not very quantitative, not very probabilistic, which is why it’s a lot of stories, a lot of emotions. And many a times we kind of overprice certain things and underevaluate others. While it is very hard to immediately look at something and strike this logical, statistical, probabilistic angle of risk and attach some sort of numerical value to it with some of these calls, because we’re not robots, we’re humans, right? We listen to stories, not look at stats. For all of you actuarial scientists, people that look at stats, it’s okay. You’re still cool. 

But the main idea is with these core understanding, you can better elaborate and better evaluate what actually matters. Most of us will never be able to really go down the statistical path and calculate and balance all the factors together to come to this risk equilibrium. But with these understanding, you can establish some sort of basic reality check as to what kind of risks matters because not all risks matters. 

Like what we have established by now, definition of risk is the effect of uncertainty on objectives. Essentially there are two functional words here: objectives and uncertainty. In other words, what kind of uncertainties matter within your objectives? So when we attach a context to this, essentially what are our objectives as retail investors? Generally there are a few: A) will be a consistent returns over an extended period of time and you can be doing periodic drawdown here, essentially means you kind of retire and you’re living off your investments. So then consistent returns over a period of time is very important, which is why a lot of endowment plans out there or state funds or corporate funds or family funds and all those kind of very structured kind of organizations, they all will have this periodic drawdown requirement because they invest to use, they invest to consume. And if you are a retiree, it tends to be the case, which is why your objective is consistent return over an extended period of time. 

Of course, there are many other people that also subscribed to the whole compounding kind of growth, which is probably objective B, which is the compound growth over an extended period of time, and you want it to be consistent. You’re not so concerned about volatility in the short term because your time period is a lot longer, but you also don’t want your investment returns to be jumping around. But generally your objectives are not as hardline as objective A, which is unique, consistent return every year, because you’re consuming out of it.

Of course, there are some people who subscribe to value investing, acquiring assets at fair price kind of idea, which is objective C, which is really just about collecting assets at a good price. Generally, these are the few objectives. Of course there are other people that are speculating, trying to be opportunistic.

What are your objectives? If your objectives are not clear, everything is uncertain. Yeah. So I know different people may have different objectives and you’re probably more unique. The reality is these three objectives are what I’ve established over time, trying to understand what people are looking for, what kind of investment returns people are looking for?

What are your objectives? So based on these three objectives, we’re going to talk about the risk factors that really matter to you. Why is this important? Because like we have established, risk is the effect of uncertainty on objectives. If we don’t know what are some of the major objectives, then we cannot really factor uncertainty. Okay? And if, uh, too many objectives, then we talk until tomorrow. 

So just these three objectives, I’m going to first throw away some of these common risk factors that sometimes I hear people talk about… relatively common, people talk about it. People are concerned about it, but I’m just going to throw them out first to tell you that I personally feel that these two risk factors are not very much of a concern to retail investors trying to achieve these three objectives. 

Number one is liquidity risk. Why I think it’s not very important because for most retail investors, your fund size are very small, relatively small. Even if you’re at a million dollars, you’re considered small in the grand scheme of the financial world, right? Any random fund has close to a billion dollars. Any less than a billion, you may not want to invest in them and blah, blah, blah… that’s a whole different story, whole different discussion. But the idea is because your fund size are small, it’s very easy for you to move money. 

Just think about it as like moving apples. Today, if you want to move 10 apples from one room to another room, maybe you just run two rounds if you don’t have a plastic bag. But if you’re trying to shift 10 boxes of apples and a thousand boxes of apples… you get the idea, right? It’s very hard. So even shifting money is a challenge. Shifting money in and out of an asset or not, is a real big headache for a lot of these guys without shifting prices. 

Think about it. If suddenly you open and want to buy a lot of a particular stock or sell a lot of a a particular fund, you will shift prices and it is not what you want. You just want to liquidate, right? So for a lot of the big guys, liquidity is a problem. And for you because you are a small investor, as long as you don’t go into the interesting corners of the financial world, stay with your index funds, your class A shares, your big companies, and what have you not. Then generally you’re fine. So liquidity is not really a problem because our fund size are small and our objectives are not crazy. 

Number two is counterparty risks, because retail investors are very protected in the financial world. If you didn’t know, I’m just going to put it out here that the financial licenses for retail investors is very, very… it’s a highest echelon. What does that mean? Which means that any company that can run open ads, like your YouTube ads or they can run bus stop ads or whatever, kind of advertisements. They have been certified to be quote unquote “the safest” in the financial market, essentially means the products that they’re selling is not wild and crazy and innovative and risk factor very, very high and whatnot, right? Because they are for the retail investors. So if you want to take that kind of license to sell to retail investors in an open fashion where you can market it on YouTube and whatnot, these licenses require you to sell some of the most boring products, which is quote unquote some of “the safest”.

And that is why counterparty risk is not really a big problem for retail investors because you will not be touching all your interesting… very bourgeois, weird products that can maybe give you a lot of, uh, much better returns, like based on what the risk capital, or what hedge funds do, but maybe a little bit crazy lah in terms of volatility, or in terms of the probability of losing all your capital or losing half your capital and whatnot. So if you are using established parties like people with brokerage licenses, robo-advisors and big fund houses… work with the banks, even insurance companies and whatnot, they all have the highest tier of license so that they can sell to you, unless you go and buy it from some weird weirdo that is on the MAS alert list or all sorts of weird shit, those guys have counterparty risks. So as long as you buy it from the established guys, they will not have counterparty risk because they are held to the highest standards. 

So then what kind of risks matter and how do we manage these risks? The first risk that really matters to retail investors is foreign exchange rate risk, essentially Forex. So when we invest locally, that means we buy stock market here, you know, like, like, um… what have you: the big banks or SIA or whatnot. Don’t buy SIA, not a stock recommendation, but yes. If you buy local stocks, you buy local properties or you start a business with your friends locally, or this mama shop auntie downstairs don’t want to do already then you buy over the business, you know, you’re investing, right? If you invest locally, you don’t need to care about exchange rate because you’re operating everything in Sing dollar. So with that in mind, this thing does not matter. 

But today, these days more and more people are looking at Hong Kong shares, US shares, buying JB property, Thailand property and whatnot. When you invest abroad, what you have to do is you probably, under normal circumstances, you will need to exchange your SGD for another currency. If you actually move money through the traditional financial system, which is the SWIFT system, most people will use the TT (Telegraphic Transmission) if you’ve not heard this term. You have to use the traditional system and to function in that traditional financial system, most people use US dollar. So if you think about it, you want to buy a Thai property, you have to buy in Thai baht. But to do that, you have to transfer Sing dollar to Thai baht, right? And to go through the international financial system, what happens? Sing dollar will have to first be transferred to US dollar, and then from US dollar, you’ll be transferred to Thai baht. 

Yes, that is the idea, which is why the exchange rate for the banks is always very shit. But over time, you start to see a lot more solutions coming up. Things like TransferWise, Revolut… not sponsored but they are using a different way to shift money. I will not talk about them today, but things may change. But until then, if you’re using the global financial system to shift money internationally, whether is it just topping up into your brokerage, overseas brokerage… I’m sure you guys have tried this. As long as you have a brokerage that is overseas, they will ask you to send to some Goldman Sachs account or some whatever account and all those are done in USD and you are subjected to exchange rates.

So in that sense, as long as you invest abroad, you have exchange rates problems. So why is that a risk? Back to the definition of risk: effect of uncertainty on objectives. What kind of uncertainty does it create? To give you the best example that happened recently, I know during March 2020, a lot of people shifted money into the US market, US stock exchange. A lot of people were saving up and preparing for the next market crash, thinking that you are some amazing guy and whatnot. If you have invested, good for you but just don’t make it sound like you predicted this, you’ve calculated this whole thing.

Well, what happened was a lot of people shifted money at that point in time, which was March 2020, and what was the situation at that point in time? US dollar went up compared to SGD, 15%. So that means usually it was trading at 1.33, 1 US dollar to 1.33 Sing dollar. At that point in time, March 2020, it was trading at 1 US dollar was 1.46 or about 1.5… close to 1.5 SGD. What does that mean? It means that there was a 15% spike in USD, the SGD exchange rate, but people went in. So when people went in, over time, somehow people made money, which is great, right? So you made money, cool stuff. But if you factor the exchange rate risk, if you make 50% from then till now, you actually effectively only made 35% because the exchange rate now is back to 1.33.

So you have lost 15% because of exchange rates. You get the idea, right? Exchange rates become a problem when you’re investing abroad and increasingly a problem as more and more people are shifting money to capitalize on opportunities all around the world. If you are investing in places like the US, Europe… I know people buying UK property or Australia, Japan, even China, these days, their exchange rates are very stable or relatively stable. It’s not that big of a problem. 

But if you invest in JB property, buy Thai… Phuket villa and buy the stock market in Vietnam and whatnot, you are in for a ride lah. They tend to be a little bit more volatile. Because they’re growing, so the government is doing a lot of policies. They may print more money, they may depreciate their currency to drive trade. All those things (are) very complicated, we will not touch it. But the idea is if the economy is growing, there are a lot of uncertainties involved and it tends to reflect in the exchange rates, so exchange rates can move quite crazily. And even if you bought a property and let’s say Vietnam, and yeah you made a hundred percent in 10 years just because there was a property boom, and a lot of population all going to Ho Chi Minh and working there so there was huge demand and yeah, property prices went up. But if you factor your exchange rates, you may have lost some money along the way because of exchange rates fluctuation, and tend to be that emerging markets exchange rates are more volatile than established markets, but it is not always the truth. It just tends to be this case. 

So with that, you realize that exchange rate risk is quite a thing, right? It is not like some random thing that does not happen very often. It is always factored in. If you see depreciation in US currency over time, you see volatility in just the Malaysian currency. Sometimes 1.2 something, sometimes 3 point something, right? You see these factors and people are buying JB property, people are buying US shares. So when you see this kind of very real volatility, just from you going to shopping at JB, then you should recognize that volatility in the exchange rate market is a problem when it comes to your objectives of investing and making returns and all that.

So how do we then respond to it? Last week, we’ve established that there are three ways to respond: risk avoidance, risk transfer and and risk reduction. This is what we are going to do with every single factor going forward. Of course, there’s risk acceptance, which means just accept and create contingency plan. That one we will not talk about it, but just on this factor of foreign rate exchange risk, how do we do it? 

For risk avoidance, of course, to avoid it, that means you just invest locally, you don’t invest abroad. Why is that the case? If your objectives are not huge, you just want your 5%, a year on year returns, or you just want to compound at 8% year on year. That means your objectives for your investments are consistent returns or compounded growth and whatnot, it’s achievable locally. That means it’s not crazy, right? 5%, 8% should be okay what, not that difficult to achieve locally. Not recommending you, but not difficult to achieve locally. Then yes, if you don’t invest abroad, that means you can choose not to invest abroad. That means your tools can be local, and in that sense you essentially avoid foreign exchange rate risks because you just invest local. 

The other way is risk transfer. What most people do will be to hedge currency. To hedge currency, this one very complicated. Of course you can directly buy insurance from insurance companies or from the banks… yes, if your pot is big enough, they do sell you this kind of exchange rate, risk packing kind of thing. But this is a bit hard. The other easy way that you can do will be to short the other currency. It’s easy in a sense that you can easily do it, you have access to it, but it’s not easy to do it. So generally, I think you shouldn’t do it lah, right?

So that is risk transfer. Under risk reduction, there is this strategy that a lot of people are propagating and I think rightfully so, because it’s probably one of the easiest, and that is 50-50. Which means to invest 50% of your money in local assets, local companies, local properties and whatnot, and 50% of your assets abroad, overseas. When you do that, actually you balance out the exchange rate risks because essentially, exchange rate is a… use one to change for the other. So if you own half-half of both sites, you will balance it off. Of course we will not go into the nitty gritty and the details. It may not be a hundred percent balancing because probably you’re not 50% in one currency only, you may have different, different countries that you invest in and they may move differently. But the idea here is as long as you hold 50% of your assets locally and 50% of your assets abroad, the impact of foreign exchange rate risks will be greatly reduced. 

Which brings me to point number two, the other risk factor that matters for most retail investors and that is concentration risk. In other words, everything put into one thing, and we’ll talk about this after a word from our sponsor. 

Okay, I want to establish this idea that if you want amazing, extraordinary yield, 20% a year, 50% a year, 100% a year, then you probably have to be concentrated. Why? If you invest in 10 different assets and you want to make 20% a year, in other words, on average, every one of them must be making 20% or more. But if you invest in 30 different assets, it can be 30 different stocks or 30 different properties or 30 different funds or some funds, some stocks, some property, whatever… 30 different assets, then in order to make 20%, every one of them will have to at least perform 20%, or on average perform 20%. What is the probability? It’s going to be pretty hard, if you think about it just based on the total number of people. It’s like, you want the whole class to get A like that, compared to “oh, I only need 10 people in the class to get A.” 

But the caveat here is if you’re going to do this, that means you must have some sort of superior abilities to choose the 10 people in the class that will get A and invest in them. So the caveat is superior abilities. But assuming that we don’t have superior abilities, we’re just average individuals trying to make our lives a bit better and manage our finances a little bit better, then what are the chances that we know how to flip property, we know how to pick super amazing stocks and outperform the market and all that? 

If we can’t do that, then concentration may become a little bit of a problem. Because if you think about it, if you have 50% of your capital in one asset or two assets, then when you look at your overall portfolio, the other assets don’t really matter as much already because the one or two assets is just going to overwhelm. Their performance is going to overwhelm your whole portfolio, and if you don’t have superior abilities that you know how to do these things, then you may run a risk that this one or two assets, they underperform everything else and drag the whole portfolio down disproportionately because they are the biggest in this whole portfolio. Get the idea? 

Concentration is a risk factor, but like we’ve pointed out previously, risk factors are not all bad. It has directions, so if you know what you’re doing and you want to be concentrated, it gives you a leverage to perform better. If you can do that superior returns kind of idea, you know what you’re doing and you believe that you can outperform, concentration will help you. But if you don’t think you have superior abilities and you just want to perform with consistent returns, compounded growth et cetera, then broad based diversified is generally the idea.

Which is why first idea, the first concept of risk avoidance from a concentration risk standpoint is to diversify. As long as you diversify, you do it broadly, you don’t concentrate yourself, right? So you buy everything, you buy the whole index or you buy a lot of different assets, and with that, you don’t all rely on one or two things. That is why a lot of asset managers will keep telling you to diversify, diversify, diversify, and they have some sort of basis. But value investors will go against them and say that “oh, we don’t want to diversify, we just want to pick companies and all that”, and that is because their objectives are different. So if your objectives is to collect assets at a fair price, then maybe concentration is not that bad for you. But if your objectives are to get consistent returns over an extended period of time, then yes, broadly diversified may be the strategy for you to avoid this concentration risk. Aha, get a better idea now?

The other one is risk transfer. How do you risk transfer… concentration risks? What you can probably do is to engage professionals with a good track record. Assuming that they have superior abilities, that means they have shown a very good track record that they have superior abilities and you can get them and you can give them the money and they will be concentrated. They will be actively managing some of this money to perform the kind of returns that they establish. Which is why people pay a premium for active managers that are performing very well, but what are the chances? So this is the idea: you want to get your objectives of performing well, better than the market, but then you are afraid of concentration risks. You can probably use the risk transfer method, which is to get someone that has performed very well using concentration method. Yeah, in that way, you kind of transfer the risk over to the other party, right? They handle it. Ultimately, it’s your portfolio yes, but they are the one managing the risk and if they don’t manage well, you drop them, change manager [laughter] 

The third one of risk reduction, once again, it’s back to diversify. As long as you diversify… broadly diversify, you’re essentially not concentrating. So ask yourself, what is your objectives and is concentration risk a thing to you? And if it is, then diversify in something that people talk about a lot already. 

Which brings me to point number three, and that is price risk. There are a lot of names for this, but essentially is: are you paying a good price? So definitely, depending on the price that you buy into, it will affect your objectives. If you think about it, you want to get 10X, a particular stock, you want to get an undervalued asset, it’s all based on price. Or if you want to enter the market, as long as you’re investing, there is a certain price that you are paying for already.  

The reality is no one wants to overpay. Everybody wants to get undervalued… get cheap, get an upperhand and whatever not right? So nobody wants to overpay, but as the market keeps growing, prices keep going higher, essentially there is a price risk. If you think about it, as long as you buy something, you transact on a certain price, there is a price risk. What does that mean? It means unavoidable, whether or not you’re trying to go for that broadly diversified… buy index funds, or whether or not you’re trying to pick stocks and have some sort of evaluation into this thing through DCA (Dollar-Cost Averaging), find the value price and whatnot… as long as you transact in the investments, there is a price risk. There’s no way to avoid it. Of course, if you want to avoid it, that means don’t invest lor. But if you don’t invest, then you essentially go against your objectives. So given your objectives, this is a risk that you cannot avoid, price risk.

What is the good price, and are you overpaying for something? Or are you underestimating how low the price will move? Because sometimes when we buy something, we think “ah, market underprice this thing”, think it’s like, it’s a dare you know, “we are going to make good money out of this because the market has mispriced it.” But then when you buy it, the prices keep going down, going down, going down, going down, going down, right? 

So this is something that you cannot avoid, but can you transfer the risk? Chances are you cannot transfer also, there’s no real way to transfer price risk. As long as you’re invested, this thing exists. But then what is the way that people do to reduce this price risk, essentially DCA lor. DCA is something people talk about a lot and in other words, dollar-cost averaging, which means to keep buying at periodic times. Every month, you keep buying. Sometimes you buy a little bit higher than your original price, sometimes you buy a bit lower because the market is dynamic, it keeps moving. 

But over time, if you keep buying consistently, consistently, consistently, you get that average best price. And if you DCA daily…. then, you know, you get the idea, right? You essentially get the most average. Higher frequency, better averages. That is the reality. So how consistent can you DCA? I’m not asking you to do it daily, but that is the idea. If you have a lot, a lot, a lot, a lot of data points, that is your best average. That is why people say DCA. DCA will solve price risk.

Of course, if your objective is to collect assets at a fair price, then do your good valuation, do your DCF (Discounted Cash Flow) and over time learn how to better evaluate assets so you don’t over pay for it. 

Different, different objectives. But these are generally the different ideas, the different risk factors that matters, and why people always tell you to diversify, 50-50, DCA… all these are just strategies to manage different kinds of risks, but people tend to oversimplify when they’re explaining this. 

So if you have not listened to the first episode of what are some core understanding of risks, I don’t know how you listen until now, but go and listen to that. That will help you. Based on today’s episode, I’m going to sum up the three risk factors that matters to retail investors and how do we go about solving it.

Number one is foreign exchange rate risks. You cannot really avoid unless you don’t want to invest abroad. If your objectives don’t need you to invest abroad, you don’t really have to. You can always go for the 50-50 idea to balance out your risk: 50 local, 50% abroad. 

Number two is concentration risk. If you want to outperform the market, you want to be able to buy very good assets and do very, very well in your performance, then you tend to have to concentrate. But do you have the kind of abilities to outperform? That is the question. If you can’t, then generally the idea is to diversify: buy broad based, buy all kinds of different assets. Then you essentially get the whole market, you will perform alongside the market, and market history has shown that it performed pretty well over even the past hundred years. 

Number three is price risk. Everybody is very concerned. Am I paying the right price? And the reality is unless you are very, very good at this thing, you don’t really know whether you are paying the right price. Because market sentiments change, you can do valuation and whatnot. What a lot of people recommend you to do is to do DCA: dollar-cost averaging. Because if you keep buying at consistent time, over time, you get the best price along the averages, and that’s the idea of DCA. 

Many of these strategies require a lot more discussion and we can do these all as we go along. But up to now, I hope you learnt something useful today! See ya.

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Woohoo! Okay, good stuff. I hope you guys learnt some good juices these two episodes… have a good understanding of risk, or at least have some core basic understanding of why do people do these things. Why people keep saying, keep saying “you need to do all these”. And some of these risks really don’t matter as much, but today I have established these three risk factors. 

I thought long and hard: what really matters to retail investors, and I hope this helps you… the different strategies that people recommend you to do like why, why? So… hope you learn something cool today.

For next week, we are going to… uh, wait, uh… for later this week, later this week, we’re getting Gus on. Gus, Gustavo is actually a very seasoned banker turned entrepreneur. Quite cheesy story these days, but I think he went through a lot, a lot, a lot, and he runs one of the biggest incubator accelerator here called Rescale Lab, which is pretty cool. I got him on to really talk about how individuals can look at becoming an entrepreneur, leveraging on your experience in a corporate space. Or should I put it like, even if you don’t want to be an entrepreneur, how do you become more entrepreneurial?

Because that is the thing that a lot of people are talking about, and so I hope that he can give us some good juices later this week. Definitely got good stuff because I interview him one mah, right? Next week we’re going to talk about some business advice for side hustlers, for indie hackers or early SMEs. Because I do think that in the future, a lot of us will have to do some sort of side hustles or even feel like you want to explore some sort of side hustles or even become your own mini entrepreneur, where you have to sell your services, as more and more work will become more contractual, more remote, more gig centric. I do think that business advice matters. So next week, I’m going to share with you some stuff as we round up the future of work. 

Yeah. Any other good questions, do let us know. We have a lot of content coming up for you. We have launched a new podcast, called Our Entrepreneurshit Show. So you can go check that out. Just search The Financial Coconut on the search bar wherever you are enjoying your podcast, you should see all the content that’s coming up from us. We’re building a lot of business-centric content so if you want to do something or your company wants to do some business-centric content, definitely email us: hello@thefinancialcoconut.com. So yeah, take care. Meanwhile, see you around guys. Bye!