Costly Risk Aversion and Your Investment Returns

Context
Safe investments are currently yielding essentially zero. In the industrialized economies, putting your money into super safe vehicles such as domestic government bonds yields roughly between 0% and 2% in nominal terms, depending on chosen maturity. Yet people are avoiding better returns in incredible proportions. This signals that ordinary people still don’t get it: excessive fear of risk is very costly, and requires a high sacrifice of returns, especially when taking into account compounding. The lack of knowledge and understanding about markets causes people to have irrational fear of markets and to freeze their savings in low-yielding assets – the unknown is always scarier than what it really is. Let’s discuss this a bit further.

Growing your money
A Gallup survey of 2015 found that the proportion of US adults holding stock went from 65% in 2007 to 55% now. For the mid-range income individuals, the proportion holding stock went from 72% in 2007 to 56% now, an incredible drop! The Great Recession caused a preference shock in the risk-return compromise and seems to have reinforced the equity premium puzzle.
 
Returns on safe assets will kill your retirement fund. There are several options to grow money other than housing, but the lack of understanding and knowledge blocks people out of stocks and forex markets for 2 reasons: 1) the direct ignorance of what is actually possible; 2) excessive fear and risk aversion caused by lack of appropriate knowledge.
 
These barriers to better returns are reinforced by psychological factors that make things worse: many “ordinary investors” tend to buy high while the market is in party mode, and sell low, because they can’t take the fluctuations and they panic once they are down 10%, thus making the paper loss a liquid reality! Sad but true.
 
Here are some approximations of investment returns in various markets right now, based on the money market interest rate, which could be earned on the forex market with various simple instruments available to ordinary people who go online on various forex platforms:

​Where do I put my money?
As you can see from the table above, safe returns in industrialized countries are very low! So where do you put your money and how do you develop a strategy to grow your savings? Obviously your personal finance advisor can help you with this question, and it is important to consult with knowledgeable people to make such important decisions, but it is time that people themselves also understand markets, how they work, and how returns on savings are possible outside of bonds, housing and extra safe deposits.
 
There are obviously a plethora of markets and vehicles in which to park money: government bonds of various maturities, corporate bonds in various sectors and maturities, stock in various sectors, housing, land, art, and foreign markets (which generally implies currency trading in one way or another). There are TONS more, this is not an exhaustive list!
 
Just for fun, here are the returns on liquid deposits on “emerging markets”:

​As you can see, the returns in these countries seem much higher… And sometimes this is actually true and even “double true”: you get a very positive gain from investments in a country, and you get a positive gain on currency movements… but you have to know what you are doing, because sometimes, the higher rates in other countries are due to risk, mostly currency risk: if a US investor puts his money in Brazilian Reals and the Real suddenly bombs, he is losing money, even if his deposit rate is high. This explains in part why we are not all throwing our money into Brazil!
 
Here is a simple example:
Suppose a US investor put 1000 USD in Brazil in 2011. Back in 2011, changing 1000 USD in BRL (Real) would give approximately 1667 BRL. The problem is that 5 years later, in 2016, the 1667 BRL are now worth about 467 USD, a more than 50% drop from his original 1000 USD! Now maybe the investor was “compensated” by very good returns while his funds were in Brazil (stock market or other markets), but maybe not!
 
The cost of investment home bias
There is a well-documented phenomenon in financial investments: people tend to favor investments in their own country, and not simply due to better returns. This can be influenced by currency risk and other factors. The problem again here is that you pay a high price for that preference for financial investments in your own country. There are significantly higher returns to be obtained in foreign markets, but the cost is to tolerate a bit more volatility and risk. This perceived risk can be decreased by better understanding global markets, which is accessible to all individuals who have normal IQ and are curious and willing to learn a bit.
 
You can earn profit from forex markets by selling or buying “currency pairs”… it sounds complicated but it really isn’t. Any normal person can setup an online account and start buying and selling currencies online for any amount from 1000$ to 100 000$ within a few days. The technical details can seem a bit overwhelming when you start, but it quickly becomes very easy, and it actually is a truly fun and exciting activity in itself!
 
The harder part boils down to understanding currency fluctuations and profiting from the fluctuations, along with returns available in foreign markets. In other words, it boils down to these questions:

1. What returns can I get in my country (stock market, housing, etc)?
2. What returns can I get in another country?
3. If I put my money in another country, what will be the currency fluctuation between that country’s currency and my currency during the time my money is in that currency?
4. How can I reasonably evaluate risk and what is that risk?

 
Here are a few examples…

​The examples are endless and the returns available in foreign markets and the forex market are worth a bit of energy and time, especially given the low returns in many markets and the fact that this actually becomes fun once you get the hang of it!
 
At the least, since markets, macro policies, globalization, powerful trends, and big fluctuations are there to stay and have important impacts on all facets of societies and your own life, it should be a personal mission to understand markets and to know what is going on.
 
The cost of staying in your own currency, avoiding the forex (foreign exchange) market, and parking your money in extra safe vehicles is high and it is time that knowledge of markets get out of large financial corporations and descend directly to more ordinary people. Even if you don’t invest yourself, at least you will be much better equipped to talk with your personal finance consultant or other investment representative.

​But how to know when big currency movements will happen and how to make money from them? You just have to understand what drives the value of currencies. It may seem complicated, but it is possible to gain a much better understanding of global markets with a bit of curiosity, an open and positive mind, and reasonable effort! This is what big investment banks do! They understand what is going on, and they make higher-than-average returns quite systematically.
 
The effect of compounded returns and investment returns makes it clear that getting a few extra percentage points of returns could be very lucrative. The risk aversion of the average person comes with a high price tag. Investing 5000$ per year for 10 years, with compounded returns:

… and this is not counting the use of leverage and potentially much higher returns… Yes, leverage is risky, so it must be used with caution, ideally by people aged below 45 and within a diversified risk strategy, or by older people who are willing to put part of their savings into more exposed markets with higher volatility and potential returns.
 
Concluding remarks: learn about markets – it’s fun!
Excessive risk aversion is costly, because it forces you into very low returns of the 0-3% range, while you could safely earn much more. Housing requires large sums and is lots of trouble. People should at least make an effort to understand markets so that perceived risk decreases, thus helping them make good decisions and know what their financial advisor is talking about.
 
The disparate, disorganized ocean of information on markets on the web creates confusion, because it is hard to discern quality knowledge from snake oil which always looks convincing and rigorous for many people, including even somewhat knowledgeable people. Don’t get me wrong: there is very good information out there, and there are very good courses out there on technical analysis and stock investments, but there is also lots of baloney! So just be sure to learn properly and in the right order…
 
As I explained in my last post, starting with technical analysis is like starting to build a house without knowing what you are doing: asking for disaster! Start with understanding what is going on with a solid foundation, then you will build on solid grounds for your investment decisions.
 
I hope you enjoyed this post and that things are a bit clearer now! Feel free to comment, share, and to contact me. Cheers!
 
YourPersonalEconomist
contact@yourpersonaleconomist.com
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