Why Most Investors Misunderstand Risk | Ep. 14

0:00 – There’s a quote from Warren Buffett that I think about often.
0:02 – In order to succeed, you must first survive.
0:06 – It’s sound simple, it’s almost obvious, right?
0:09 – But in practice, very few investors actually build their investment strategy around that
0:15 – idea.
0:16 – Most investors spend the vast majority of their time just thinking about one thing, how
0:19 – to increase returns, how to squeeze out a few extra percentage points along the way.
0:24 – But very few investors, they spend time thinking about something much more important.
0:28 – How to design investments that survive uncertainty.
0:33 – Over the course of a long investment career, that difference quietly determines who compounds
0:38 – wealth and who eventually loses it.
0:41 – Welcome back to the Sage Investor.
0:42 – My name is Brian Spear, and my mission is to help you generate cash flow and build legacy
0:46 – wealth in a tax-efficient manner, because that’s what I’m trying to do for my family,
0:49 – and I’m helping as many people as possible do just that along the way by sharing all the
0:53 – secrets I learn along that path.
0:55 – Today, we’re going to talk about one of the most important ideas in investing, and it
0:59 – is understanding risk.
1:02 – Because if you misunderstand risk, you will misunderstand investing.
1:06 – If you misunderstand investing, you’re eventually going to pay for it.
1:09 – Earlier in my investment career, I met an investor who had built an extraordinary real estate portfolio.
1:15 – This was a family business that had been operating for decades, hundreds of millions
1:19 – of dollars of office properties, suburban office buildings in multiple different markets,
1:24 – and by almost any measure, this investor had done a fantastic job.
1:29 – The portfolio had grown steadily over time, the family had accumulated significant wealth.
1:34 – It was multiple generations in the business by this point, and importantly, the investor
1:39 – believed he’d been extremely conservative, because the portfolio only had about 50% leverage.
1:46 – If you ask most investors what excessive leverage looks like, they’re going to say something
1:50 – like 85% LTV, 90% LTV, and that’s what people picture when they hear the phrase over leveraged
1:58 – real estate.
1:59 – But when we looked deeper into the portfolio, something else became clear.
2:05 – The loans were fully amortizing.
2:07 – The loan terms that were relatively short, and the debt payments were very heavy.
2:13 – Even though the loan to value looked conservative, the cash flow cushion was extremely thin.
2:19 – The portfolio was operating only at about 1.1 to 1.2 debt service coverage ratio, which
2:24 – meant that there was almost no margin for error.
2:27 – For decades, everything worked fine.
2:30 – Tens came in, they paid rent.
2:31 – Debt service got paid like clockwork.
2:33 – The portfolio kept on growing.
2:35 – But then in 2020, COVID hit, and the office tenants, they stopped paying.
2:40 – Collections dropped dramatically.
2:43 – And suddenly, this investor, who’d spent his entire life building this family’s wealth,
2:48 – was facing the possibility of losing the entire portfolio.
2:53 – Not because the assets were bad.
2:55 – Not because the leverage was extreme, but because the structure was fragile, and that experience
3:01 – illustrates something incredibly important about investing.
3:05 – Risk, it rarely is obvious when times are good.
3:08 – It just hides.
3:10 – It hides quietly inside the structure of an investment, until something unexpected exposes it.
3:16 – If you went to business school or you took a finance course, you probably learned that
3:21 – risk is defined as volatility, as beta.
3:25 – But how much the price of an asset moves around, how much it goes up and down?
3:30 – If the price moves a lot, the asset is considered, quote unquote, risky, right?
3:34 – If the price moves very little, then the assets considered more safe, and that’s the academic
3:40 – definition of risk.
3:42 – And from a mathematical perspective, it’s unbelievably convenient.
3:45 – I feel like a lot of professors ultimately chose that because they could plug it into
3:48 – a spreadsheet.
3:49 – It’s easy to measure, right?
3:50 – That volatility, it is very easy to measure.
3:53 – You could plug it into formulas.
3:55 – You can calculate the sharp ratio.
3:57 – You can create really elegant financial models and put it into a pro forma.
4:00 – It’s nice.
4:01 – It’s convenient.
4:02 – But here’s the problem.
4:03 – That definition of risk, it does not match how investors actually think in the real world.
4:09 – No investor has ever said, look, I don’t want to buy that asset because the price might
4:13 – go up and down really quickly.
4:14 – It might be volatile, right?
4:15 – What they actually say is something much more simple.
4:19 – They say, I don’t want to invest in that deal because I don’t want to lose my money.
4:22 – And that’s actually what risk is, right?
4:24 – It’s trying to avoid capital loss.
4:27 – It’s trying to avoid losing your money.
4:30 – And that distinction is incredibly important.
4:32 – An investment can be volatile without being risky.
4:36 – An investment can also be very stable while actually being extremely risky.
4:43 – One of the investors who’s written most clearly about this is Howard Marx.
4:46 – I think he’s done a pretty good job of explaining risk very, very well and some things that are
4:51 – incredibly insightful along the way.
4:53 – He’s got this idea in this concept that risk cannot be measured precisely.
4:58 – It cannot be measured inside of a spreadsheet, the way that a professor would otherwise want.
5:03 – It cannot be reduced to a single number.
5:06 – And most importantly, risk is often invisible.
5:10 – When markets are really stable, when liquidity is abundant, when asset prices are rising,
5:16 – risk appears to disappear.
5:18 – But in reality, risk is often just quietly building underneath the surface.
5:25 – During those periods of rising inflated prices along the way, risk continues to go up and
5:30 – up and up.
5:31 – And it only becomes visible when something goes wrong.
5:34 – I want to pause here and actually just share my screen for a moment because I think a
5:38 – picture is worth a thousand words right?
5:40 – And it can help explain this idea far more clearly than words alone.
5:45 – And for those of you who are just listening on an audio, I’m going to do my best to describe
5:48 – what I’m showing you here.
5:50 – If you took a finance course in college or in business school, this first chart will probably
5:56 – look very familiar for you.
5:57 – On the horizontal axis, the x axis, you’re going to have risk.
6:02 – And on the vertical axis, the y axis, you have return.
6:07 – It just slopes up and to the right, very simple chart.
6:10 – And the message is very straightforward.
6:13 – The more risk that you take, the more return that you should expect.
6:19 – And that’s the standard academic framework.
6:22 – Now, on the next chart, it becomes a little bit more specific here.
6:26 – It plots various different asset classes along that same line.
6:31 – So you kind of on the very bottom left section, you have money markets.
6:34 – And then as you go up the risk spectrum, you go to treasuries and bonds and stocks and
6:39 – real estate and buyouts.
6:40 – And then ultimately at the top, in terms of the risk parameters, you’ve got venture capital
6:44 – with venture capital kind of sitting to the farthest up into the right on the highest
6:48 – risk, highest return part of the spectrum.
6:52 – And on the face of it, that sounds reasonable.
6:55 – But here’s the problem.
6:57 – It is not a holistic view of risk.
7:00 – It is incomplete because the implication of this chart is just dangerously simplistic.
7:07 – The implication here, it implies that if you take more risk, that you will get more
7:13 – return.
7:15 – But obviously that is not true because if taking more risk automatically gave you a much
7:22 – higher return, then it wouldn’t be very risky at all with it.
7:26 – And that is the flaw.
7:29 – This chart leaves out one of the most important parts of investing, the range of possible outcomes.
7:36 – And that’s where the next charts coming a little bit more useful here.
7:39 – So this next chart walks through something that the first chart is missing.
7:43 – It’s a widening distribution of outcomes as the risk increases.
7:49 – This is really what beta is.
7:51 – The higher you move along the risk spectrum, the wider the bell curve becomes.
7:58 – And it’s spelled out a little bit more clearly on this respective chart.
8:02 – Prospective higher return may increase with the added risk, but so does the variability
8:08 – of returns and also the prospect of loss.
8:13 – And this is a much much much much much better way to think about risk.
8:18 – Because now we’re no longer just pretending that a risky investment simply means higher
8:24 – expected return.
8:26 – We’re actually acknowledging reality that as the higher level of risk is taken, yes,
8:33 – the upside may be greater, but the downside also becomes much much much more severe.
8:40 – And that range of likely outcomes because becomes much wider.
8:44 – And that’s what people are really doing, right?
8:46 – That’s really what we’re doing when we’re allocating capital.
8:49 – That’s what you’re dealing with.
8:50 – So when we try to make it a little bit more concrete here, and we’ll take venture capital
8:54 – as an example, you know, a venture capital pitch deck.
8:58 – What I can promise you is when they’re sharing you that that venture capital pitch deck,
9:02 – it’s going to have let’s call it a 30% internal rate of return projection fine.
9:07 – But what that pitch deck is not going to say is there’s very likely a massive significant
9:12 – chance you’re going to lose all your money.
9:14 – Probably that’s probably what’s going to actually occur, right?
9:17 – And yet, in venture capital, that is exactly what happens all the time.
9:20 – These deals do not become over.
9:22 – Most deals do not become Airbnb.
9:24 – Most deals do not become unicorns.
9:26 – Many, I would say, most ultimately go to zero.
9:29 – So the problem with the original chart, the simplistic form, is that it presents a single
9:35 – expected return while hiding the violent spread of outcomes that actually comes with risk.
9:41 – That is the deeper meaning of beta and standard deviation.
9:45 – It’s not just some academic statistic.
9:48 – It’s telling you that the future range of outcomes is much, much less certain.
9:53 – And when you start to understand that, you start to realize why risk cannot be reduced
9:58 – to one neat, tidy number, which brings me to what I think is, you know, the most important
10:04 – practical takeaway from this whole discussion, okay?
10:07 – If two different investors out in the marketplace generate the same exact return, two different
10:12 – investors generate the same exact 15% rate of return.
10:16 – How do you determine which is actually a better investor?
10:21 – And that’s where the next two charts come in.
10:24 – You know, I believe these two charts provide exorbitant amounts of information and a ton
10:28 – of value to limited partners out there in the marketplace.
10:31 – It’s the idea and the definition of determining the difference between a skilled investor and
10:36 – a lucky idiot.
10:37 – Let’s walk through these two things here.
10:39 – So on this chart, what you’re going to see is an investor who earns the same exact
10:43 – rate of return as the benchmark, but does so while taking less risk.
10:49 – The portfolio sits to the left of the benchmark on the side of the risk axis and at the same
10:55 – exact rate of return.
10:57 – And the horizontal gap there is labeled value add.
11:00 – That’s value add to the marketplace.
11:02 – Let’s say two different investors, both the chief of 15% rate of return and one of them
11:05 – does so with significantly less risk.
11:08 – The guy who does so with massive significantly less risk is adding alpha.
11:13 – We’re actually adding value to the marketplace.
11:16 – This chart is a beautiful visual because if they’re both generating 15% returns while one
11:21 – of them generating significantly less risk, obviously the investor taking the less risk
11:26 – is clearly the superior capital allocator.
11:30 – That is not luck.
11:32 – That is skill.
11:33 – And ultimately, that’s what we try to do when we go into the marketplace.
11:36 – That’s our tactic.
11:37 – In the next chart, we can show you kind of an opposite version of another way to add alpha.
11:42 – Another way to add value to the marketplace.
11:45 – Here the portfolio takes the same exact amount of risk as the benchmark but ultimately earns
11:51 – a higher rate of return that is yet another way to add value to the marketplace.
11:56 – The value added is vertical instead of horizontal.
12:00 – They take the same amount of risk but ultimately generate a better outcome.
12:04 – That is also alpha.
12:05 – That is also skill.
12:07 – So now we can finally say something much more intelligent than the original finance textbook
12:12 – chart.
12:13 – A skilled investor is not simply the one with the highest nominal rate of return.
12:20 – A skilled investor is the one who either generates the same return with less risk or generates
12:28 – a higher return with the same risk.
12:31 – And that is the difference between a skilled investor and a lucky idiot.
12:36 – And as a limited partner, your job is to find the people who actually add that kind of
12:41 – value to your portfolio.
12:44 – Over the course of the last 15 years, there have been a lot of individuals that have gotten
12:47 – involved in this without exorbitant amounts of experience.
12:52 – And I will now say without exorbitant amounts of skill, but they still did pretty well.
12:58 – What we’ve been talking about here is this idea and this concept of risk adjusted returned
13:02 – and that’s where a lot of investors get confused during periods of falling interest rates,
13:07 – which we’ve been on a downward trajectory of interest rates for 40 years until the massive
13:12 – increase over the last couple of years, right?
13:15 – When you have those falling interest rates or rising asset prices, many investors appear
13:21 – to be extremely skilled because everybody’s making money.
13:26 – Businesses are compressing, asset values are rising, deals look brilliant.
13:31 – And sometimes the results of those individual transactions are not the result of skill.
13:39 – They were simply the result of favorable conditions.
13:43 – When the environment changes, the difference between skill and luck becomes way more obvious.
13:50 – As Warren Buffett famously said, only one that tied goes out.
13:53 – Do you find out who’s been swimming naked, right?
13:56 – And that’s what we’ve seen in the syndication space.
13:59 – We’ve got a lot of different limited partners that ultimately invested, called $100,000
14:02 – in a deal-specific syndication with a multifamily syndicator.
14:06 – And they did a fixed-and-flip business model from 2017 to 2020 and they doubled their money
14:11 – and they did great congratulations, moved to 100K to 200K.
14:14 – And they might have done it again from 200K to 400K, congratulations.
14:18 – But then unfortunately on the third fixed-and-flip, same-exact business model, same-exact operator,
14:23 – they assumed he was great because it was just favorable conditions.
14:26 – But then market conditions changed and you find out who’s swimming naked when the tide
14:31 – goes out.
14:32 – Now that $400,000, poof, oftentimes, unfortunately, you have paused distribution capital calls
14:37 – sometimes total loss of capital.
14:40 – And to be honest with you, this is why we’ve loved the niche of mobile home parks for
14:45 – so long.
14:46 – I’m going to just give you some charts on this topic and why they produce, from my perspective,
14:50 – the best risk-adjusted returns.
14:52 – Here’s a chart that basically shares some data from 2018.
14:55 – So this data is a 10-year total return chart from 2008 through 2018, which basically shows
15:03 – that all sorts of different individual real estate niches from shopping centers, industrial,
15:08 – office, lodging, apartment, self-storage, mobile home parks, all these various different
15:11 – niches, mobile home parks are at the top of the list, nearly 20% annualized returns.
15:16 – And on the right side of the chart, you realize that that occurred the highest rate of return
15:22 – for mobile home parks while having also the lowest beta, the lowest risk.
15:29 – Those two things and the vast majority of other investments and sectors do not exist concurrently.
15:35 – But because we’re in a very unique, modest-sized, fragmented real estate market, you have the
15:39 – opportunity to generate really high-quality risk-adjusted returns.
15:44 – That’s why we love mobile home parks.
15:46 – Let’s take another gander here at the top right portion of the chart for beta for risk,
15:49 – where you see lodging.
15:51 – Why is lodging at the top in terms of the beta?
15:54 – Because obviously, as the nation’s GDP ebbs and flows, whether you’re in a recession or
16:00 – a booming economy, there’s going to be a lot more disposable income in the pockets of
16:04 – consumers, and they’re going to be willing to spend more, they’re going to be willing to
16:08 – travel more, they have way more discretionary income, and that’s the result.
16:11 – So let’s see what happened after COVID, right?
16:13 – On COVID hit in the first quarter of 2020, fast forward a few different quarters, right?
16:17 – Now all of a sudden, this is data from September of 2020, and you could see what happened to
16:20 – the property values.
16:22 – You guys remember how it got absolutely crushed?
16:25 – Lodging is at the very bottom of the list when discretionary income dried up the value
16:31 – of lodging, i.e. hotels, 25% dip in the value of the portfolio immediately within nine months
16:38 – of this coming to fruition.
16:40 – People are out shopping significantly less across all different property types, down 10%,
16:44 – office was down nine, apartments were down 8%, mobile home parks, they were up, they were
16:51 – up 3% from pre-COVID, because let’s take a look at how long have a food, water, and shelter
16:59 – been in high demand since the the beginning of time, the most essential housing in the marketplace
17:06 – is always going to be in high demand, regardless, and this is why we just appreciate it so much,
17:11 – right?
17:12 – What I’m trying to achieve from my family, I’m not trying to generate the highest returns,
17:17 – I’m personally trying to achieve the best risk-adjusted returns in the marketplace.
17:22 – I’m trying to achieve the best return that I can while taking an exceedingly nominal amount
17:27 – of risk along the way.
17:29 – Why?
17:30 – Because I’ve been so fortunate to already have one in the eyes of society.
17:35 – This is the old adage, you only need to get rich once.
17:38 – We’ve already done a pretty decent job of building some wealth along the way, and now
17:41 – my job is to ensure that we just never lose money, and we are living our version of the
17:46 – American dream.
17:47 – So I’m trying to generate the best return that I can while ensuring that I take exceedingly
17:53 – negligible amounts of risk.
17:55 – In plain English, the asset class generated the best return in any real estate sector with
18:02 – the lowest volatility among all of the real estate sectors as well, and that is incredibly
18:08 – important.
18:09 – I’m personally not trying to generate the highest return possible.
18:14 – I’m trying to generate the best risk-adjusted return possible, and that is a very different
18:20 – objective.
18:21 – And mobile home parks have historically been compelling for exactly that reason, safe,
18:28 – predictable, durable demand.
18:30 – When the world gets punched in the mouth, some sectors are much more fragile than others.
18:36 – Now this, you know, extends, this chart extends the idea over a longer time horizon.
18:41 – The Green Street Commercial Property Index, this is charted from 2016 through 2026, and
18:49 – it shows manufactured housing at the top of the group as well, ahead of industrial, while
18:55 – office in the malls are dramatically lower near the bottom.
18:59 – You know, I would add one more structural reason as to why this is the case.
19:03 – It’s the supply growth in mobile home parks.
19:06 – This chart shows manufactured housing with essentially no new annual supply growth through
19:11 – 2028, compared with much higher expected growth in data centers, self storage, industrial
19:17 – apartments, lodging every other real estate sector has a lot of additional growth in
19:20 – various different sectors in terms of supply, except for mobile home parks.
19:26 – So when you put all that together, you put durable demand, low new supply, lower volatility,
19:33 – strong long-term returns, you begin to understand why certain sectors can generate outsized
19:40 – risk-adjusted returns.
19:42 – And to me, that is the game.
19:45 – Not chasing the flashiest return.
19:48 – Not trying to hit home run after home run every single year, but generating the best return
19:54 – that I can while taking the least amount of risk necessary to get there.
20:01 – That is what thoughtful capital allocation looks like.
20:04 – And that is the difference between an investor who is actually skilled and one who simply
20:09 – got lucky in a favorable environment.
20:12 – And this is why bull markets are so deceptive, because in favorable environments, lucky idiots
20:19 – often look like skilled investors, which is exactly why risk gets misread for so long.
20:27 – But during bull markets, something interesting happens.
20:31 – Risk begins to disappear, or at least it appears to disappear.
20:36 – Credit is abundant.
20:38 – Everything is easy, asset prices continue to rise, and leverage it begins to feel safe.
20:44 – Investors begin to believe that higher returns are simply the result of better opportunities,
20:49 – but in reality, something else is happening.
20:53 – Risk is accumulating quietly inside of the system, and history shows us that the periods
21:00 – of apparent stability are often the moments when fragility is building the fastest.
21:08 – The minute that your Uber driver starts giving you stock tips is the minute that you need
21:12 – to sell.
21:13 – I remember being inside of a restaurant in 2007 when the waitress is telling me about
21:17 – the handful of condos that she’s been fixing and flipping in Miami.
21:22 – That’s when you should be selling condos.
21:25 – Back when I was in school, you had to use to make trades to buy and sell stocks through
21:29 – your broker.
21:31 – When I was in school, literally one of my teachers during the middle of our class, he had a
21:35 – phone in the room.
21:36 – We picked up, and he was telling the man to buy and sell shares of the latest tech
21:41 – fad.
21:42 – That is when you need to ultimately get out of the marketplace.
21:45 – When your literal teacher during school is ultimately buying and selling shares of Yahoo
21:50 – and the like, okay?
21:51 – When everyone is talking about a tip of this time to run for the hills.
21:55 – Same thing with Bitcoin.
21:56 – Oh my gosh.
21:57 – Can you believe it?
21:58 – Right?
21:59 – If you’re hearing about buying Bitcoin after it’s already had the thousands and thousands
22:05 – of percent run up, and somebody that has no idea what’s going on in the investment world
22:08 – in general is bringing that opportunity to you, oftentimes might need to take pause in
22:13 – advance of continuing to move forward.
22:15 – This is where the idea and the concept of black swan events becomes very important.
22:21 – The term was popularized by Nassim Teleb, and a black swan event is something that is
22:27 – rare, it is unpredictable, and it has massive consequences.
22:32 – There’s many examples, including the 2008 financial crisis, the COVID shutdown, or just
22:39 – sudden credit market freezes, and one of Teleb’s most important insights is this.
22:45 – It’s that black swans do not usually create the risk.
22:49 – They reveal the risk that was already present, which leads to the most important question
22:55 – for all the investors that are out there.
22:57 – If extreme events are inevitable, and if risk is often invisible until those events occur,
23:07 – then how do great investors build portfolios that survive black swan events?
23:13 – Successful investing requires two things, generating returns and controlling risk.
23:20 – And understanding that difference is the foundation of becoming a truly thoughtful
23:24 – capital allocator.
23:25 – I’m going to go deeper on how to plan for black swan events in the next one.
23:30 – We’re going to be answering how do great investors design portfolios to survive uncertainty.
23:37 – We appreciate you spending some time with us here today.
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23:44 – review.
23:45 – We appreciate you guys spending some time with us.
23:47 – Until next time, you’d be great.