A perpetual motion machine can't buck the laws of physics, and you can't buck the laws of finance

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

Many scientists – and more than a few frauds – have claimed over the centuries that they can beat the law of the conservation of energy. They’ve bashed together ball bearings, pumped water using water, and toyed with magnets. And for a while, some machines looked just a refinement away from reality.

But today, physicists scoff. We’re wedded to the laws of thermodynamics and the principles of entropy. A schoolchild could figure out the flaws in some of the early machines, but even the modern theoretical incarnations have been debunked. There are invariably energy inputs and outputs that 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 a souped-up version of 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. If the market falls your capital is usually protected up to a certain point, after which it falls, too.

That’s the simplest sort, by the way. The really complicated ones mix several indices or stocks to produce something so opaque you might as well be buying magic beans. They also introduce counterparty risk, since they’re usually based on derivatives backed by investment banks.

Even professional advisers struggle to evaluate this concoction of risks. What hope does the average bloke at his bank?

How many buyers understand that by choosing a market-linked structured bond over an index tracker they usually forgo dividends, which over five years might protect as much a 15-20% of their downside anyway? How many have studied the history of market falls?

Some even complain when the market rises strongly, but their bond’s returns were capped. They missed out – not fair, they say!

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

The point though is that these structured products are actually ‘risk transformation machines’.

They are marketed as reducing risk for the investor (“guaranteed!” “bond!”), but in reality they are swapping one risk for another – including the risk that a lot of your returns are going straight into the provider’s back pocket!

The law of investing risk

For fun, we might write a 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.”

I don’t mean this to be literally true. For a start, diversification provides a ‘free lunch’ that reduces risk. (There goes my Nobel Prize!)

Also note that I’m not saying some investments can’t be riskier then others. 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 instance, swapping dull blue-chip shares for high-flying growth shares is necessarily riskier for a particular individual. Especially as it’s impossible to divine the future, or even to value the market – let alone consider what happened in a parallel universe where things played out differently.

For instance, the likelihood you’ll do badly by investing in growth shares might be much higher than if you’d invested into a broad index fund, but the returns if you do well could be far greater. Academic studies suggest value shares should beat growth over most time periods, but they might not for yours.

And that’s critical. We never truly know the odds we’re betting on.

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 more power to you for being sensible.

But understand you have potentially 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 bonds as priced for a fall3. Bonds have been through a 30-year bull market, and the yields are very low. It certainly seems likely that yields will go up, depressing prices. That makes bonds riskier in their view.4

People are of course quite entitled to decide that bonds are not right for them.

If you think, for example, that, a 0.25% real return on a ten-year bond is not worth the risk that inflation will turn out to be higher and so your real return negative, you may decide to reduce or eliminate your holdings of bonds.

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

If you go 100% into shares, for example, then you have swapped the near-certain risk of low real returns from government bonds for the possibility of doing much better, but also the chance that some years your portfolio may fall 30% or more in value. Whereas the likelihood of that happening to a basket of UK government bonds in any one year is tiny.

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

To me, deflation is dead seems a curiously certain statement to make in a world where the US and European central banks have failed to ignite inflation despite the greatest monetary easing we’ve ever seen.

But that’s not the point. The point is they might be right or wrong, not that they will or won’t be. We can’t invest in the counterfactuals, only the reality that unfolds in our lives over time, and this uncertainty means most of us will want to 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 much of the next 20 years.

You think the risks of low returns from bonds are much higher than the risks of deflation? So do I, for what it’s worth. But don’t think you’re not taking on new risks if you load up to the gills in equities as a consequence.

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 and your portfolio is lower than when you started.
  • Dismayed, you decide to switch to a diversified portfolio instead with your remaining money. Volatility is reduced, and sure enough your portfolio returns 6-10% a year. However after three years you calculate you could have doubled your cash if you’d stuck with your smashed-up growth shares.
  • You decide you have zero risk tolerance, so you only save in cash. You pay for your peace of mind with the risk of not having enough money to retire on because the returns from cash are so poor.
  • To try to boost your returns, you lock your cash away in a five-year bond. But have you remembered the time value of money?
  • You want an income in retirement so you buy dividend-paying stocks. You get your steadily rising income. However you overpaid for your shares during a period of dividend mania, and your portfolio hugely lags the index. (You don’t mind? Great – that means 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. And it does well, but you forgot about the currency risk you added. Your returns are halved. (Or maybe they 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 stuck in year two with a bill to replace the roof, or your tenant turns out to be a nutcase and you end up in court.)
  • You decide shares are too risky so you give your money to a fund manager with a mysterious process that returns a 10% every year. Oops, he was Bernie Madoff!
  • You and your Nobel Prize winning buddies devise an excellent scheme to make steady returns whatever the climate through arbitrage. You’ve swapped short-term volatility for modest but positive returns, as well as the risk of catastrophic failure – except you don’t see the latter, because it’s not in your model. Eventually, catastrophe occurs and your fund, LTCM, goes bust.

The list is literally endless.

At your own risk

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

Also, my First Law of Investing Risk is just meant as a thought provoker, not as a genuine principle of finance. (My real first law is that 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…

Got any good examples of transformations of investing risk? Please share them in the comments below.

  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 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.

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