Why “Risk-Free” Carries the Biggest Risk
The fundamental relationship between risk and reward in the financial world is undergoing a dramatic change. Today, the instruments which were traditionally used to preserve capital cannot even handle the task of protecting against losses. Ignoring these fundamental changes is no longer an option for serious investors. If you expect to preserve capital, let alone increase it, you have to rethink your attitude to risk, says Alan Vaksman, founder and managing partner of the international investment company Digital Horizon.
Financial injections into developed economies have never been bigger. The Fed’s data shows that the total U.S. money supply (monetary aggregate M2) has grown by $4.57 trillion or 27.6% since January 2020, reaching $19.67 trillion in February 2021. The European Central Bank balance sheet (monetary aggregate M3) has already reached €7 trillion, raising from €4.67 trillion in 2019.
As the twelve year-long zero interest-rate policy continues, monetary depreciation has sped up and impacts even the richest segments of the population. Maintaining the same standard of living now comes at an increasingly higher price for middle and upper classes alike.
Back in the day, investors could rely on bonds, gold, real estate, and other traditional financial instruments. Now, these assets cannot beat inflation at its current rate and it’s become a complex issue that cannot be solved by a traditional “rate hike”. To preserve and also increase capital, investors need to rethink their approach to risk and financial management.
Bubble or a new growth rate?
I’ve been working in the risk sector for almost 20 years. In the early 2000s, this area was going through fundamental changes: the Basel II Accord laid the foundation for the revised international capital framework. As a result, banks started to utilize not only margins but also risk-adjusted return on capital. Today, the sheer amount of liquidity in circulation and availability of “risk” money are drastically different from those of 10–20 years ago, and the speed of its growth is unprecedented.
Not so long ago, if you wanted to build a company worth $1 billion, it would take several decades of hard work: organizing business processes, making profits, and reinvesting. Now, you can achieve the same in 3–5 years, while showing losses only — profits are no longer required. It would seem that the new reality should have caused a qualitative leap in understanding of risk reward, but so far, changes are taking a very long time in the investment community.
Traditional analysts are labelling anything “fast growing” as economic bubbles, including space technologies, SaaS (software as a service), biotechnology, and many other promising industries, and then wait years for corrections. They certainly have the right to do so, but in that case, they should not be surprised by effectively losing money for their clients.
Today, a standard investment portfolio where 40% is allocated to real estate, 35% to low-risk bonds, and the remaining 25% is invested in the stock market, yields, if managed very well, 5% annually. This is considered a very good result, but taking the real inflation into account, this strategy only delays the inevitable.
The choice is simple: either have alternative asset classes in your portfolio, or effectively lose capital.
Rapid increase in opportunity cost
New economic conditions require us to change the very concept of risk/reward. The risk is no longer just about managing the downside. In an increasingly fast changing world, risk management is also about managing the opportunity costs. If you didn’t invest in Tesla, Twilio, CrowdStrike, and Fiverr two years ago, you’ve lost the opportunity for 400–500% portfolio growth.
A new perspective on risk allows us to see opportunities where conservative managers see stop signals. Thus, the recent correction of about 15–20% in IT shares triggered a spike in negative forecasts. But taking into account a more than 100% average growth of many companies, this correction does not look as tragic. In the fast-paced environment, the purely traditional approach is likely to lose in both bull and bear markets.
Today, taking on a reasonable risk to increase capital in the long term involves allocating funding to alternative assets and willingness to accept negative trends for certain periods. Since I work in venture capital, 40% of my portfolio is allocated to alternative debt and venture capital investments. But even with a moderate risk tolerance, these investments should take up at least 15%. Good stocks bring 30–50% annually, while successful investments in venture capital can multiply capital — three to five times and even more.
Overpaying is not the same thing as investing
The main principles for making money on venture investments are as follows: invest in many companies, invest in industries and technologies that you understand, invest with the long-term perspective. For this reason, venture funds are created for a minimum of 10 years and diversify risks by investing in multiple companies — usually 5–10 startups per year and around 20–30 projects in total. Some of them will be closed down or bring significantly less returns than expected; the rest will bring multiple returns by becoming a part of the new economic and technological cycle.
The financial world has come to a point where it needs to break out of its comfort zone, rethink how it has been operating for the last 50 years, and start taking risks in a new way. The security offered by traditional investment instruments is now just an illusion, while alternative asset classes are offering a new way to not only protect capital, but increase it in the current environment. It’s time for traditional investors to move to the next level and take an active part in the future instead of sitting and waiting for the past to return.
Author: Alan Vaksman, Founder and Managing Partner at Digital Horizon.