Actuarial risk is the risk that arises from an insurer developing funds via the issuance of insurance policies and other liabilities. In financial terms, it is the risk that the insurer has charged too little for the options that it has sold insured’s in the form of the provisions and promises embedded in their insurance policies. In such cases, the insurer cannot expect to achieve satisfactory cash flow in the long run. As conceptualized, however, actuarial risk would be valued and analyzed more from an options pricing point of view than from the traditional actuarial pricing point of view. The most obvious actuarial risk, of course, is the risk that mortality or morbidity experience deviates negatively from that implicit in the insurer’s pricing. This could happen because either projection themselves were based on an inadequate knowledge of the loss distribution or losses exceed projections in the normal [Read more...]
Sure, there are other investments such as bank deposits, options, insurance, and closely held businesses. There are also other risks and rewards. But this exercise is a very over simplified way of assessing risk and reward, and serves to put into perspective the fears and aspirations investors have for the way they invest money.
Consider quality common stocks from the point of view of risk and reward.
First, consider continuity of income. It is rare, indeed, that dividends from stocks are not maintained. Sure, individual companies may periodically reduce dividends when earnings are hurt by cyclical or competitive pressures, but the mainstream of corporate objectives includes regular and consistent dividend payments. It is certain that stocks produce income more consistently than any of the other investment media, with the exception of U.S. Treasury Bonds and corporate bonds; in fact, most of the other investment media pay no income whatsoever. In this category, I rank stocks a seven but would not quarrel with those who give them a six.
Moving to the level of current income, meaning the current rate of return, stocks in recent years has, on average, paid a rather low rate of return. But, as has already been shown, this low rate of return does not necessarily suggest a lack of ability to pay higher dividends. Rather, it is a conscious decision on the part of corporate management to retain earnings to provide capital for future growth in both earnings and dividends. I rank stocks a six.
For predictable capital appreciation versus possible depreciation in value, stocks again rate high, or at least, above the norm. The long-term record proves this to be the case. Although some will make a case that other media might perform better from time to time, most other investments incur extreme volatility, are subject to fads and fashions and, most certainly, are unpredictable money makers. Quality fixed income investments have low risk of capital loss but limited, if any, chance of appreciation (although they do fluctuate in price).
Likewise, real estate investments may produce attractive profits, but as we witnessed during the 1990-1991 recession, property prices can plummet in value. One of the perceptions of the risk or reward of stock investments is gleaned by the fact that stock prices fluctuate up and down not only on an annual basis but, literally, from hour to hour and day to day. Those who watch short-term quotes of stock prices get the impression that they are volatile, which really is not the case. I give stocks a five and could make the case for a six or seven.
The same type of analysis is possible for potential income appreciation versus depreciation, and here I rank stocks very high. Predictability of better dividends in the future is almost axiomatic, has historical precedence, and is as close to being assured as almost anything. In this category, I give stocks a nine, while recognizing that investment grade real estate also deserves high marks.
Since there is high predictability of capital and income improvement, stocks obviously rank very high as far as protection against inflation. I score them at eight in each of these categories, although some may disagree. Indeed, in this area, I would not argue with those who would rank real estate investments higher.
Risk is really in the eye of the beholder. All of us take multiple risks each day, although we rarely recognize them as risks, as such. When we cross the street, we are taking a risk, although we regard that not as much as a perilous trip as the achievement of a goal, namely to get to the other side. And so it is with other things we do. I have logged millions of miles flying on airplanes, fully aware of the danger posed by such transportation. In fact, I reluctantly admit that I have always been a “white-knuckled” flyer, and for some. Very good reasons. Among them: (1) I do not understand aerodynamics; (2) it seems to me to be unnatural to be flying at 30,000 feet above the earth’s surface; and (3) I have a profound fear of heights.
But my rational self tells me that flying is safer than most forms of transportation, that the odds of an accident are very low, that pilots are well trained, that there are built-in safety precautions, and so on. And, so, while I still have a fear of flying, I am also willing to fly because it is the only practical and expedient way to get from one place to another when traveling long distances. Even the events we enjoy during our leisure involve risks. A tennis player risks twisting an ankle; a golfer shooting for the green risks going into the trap; a baseball batter risks being hit by the pitch; a bridge player risks going down at his contract because his bid is too high; a gardener risks losing an eye from a stray tree branch. In an attempt to make money, there are similar risks. Having a job implies a risk of losing the job; owning a business includes the possibility of the business failing.
On and on we could go—essentially everything we do involves some risk. But we do what we do because there is also a reward in one form or another, and most of the time we focus on the task at hand rather than the associated consequences. So, too, should be the case as far as the investment of money is concerned. There is a risk in every investment decision and action, but there are also potential rewards. The only true method of analyzing risk is to couple the degree of risk to the degree of reward, a statistic commonly known as the risk- reward ratio.