First rule of investing: Risk is not inherent in an investment; it is always relative to the price paid.
Seth Klarman - Hedge Fund Manager & Author of 'Margin of Safety: Risk Averse Value Investing Strategies for the Thoughtful Investor'
Financial innovation in pursuit of that elusive holy grail of investing, the ‘low-risk, high return’ product, has been shown to be highly damaging to wealth. For example, prior to the credit crisis, Mortgage Backed Securities (MBS), essentially shares in a package of home loans, were marketed as a new stable higher yielding alternative to traditional low risk products.
But with the ability to package and sell their mortgage books to investors, banks no longer assumed the risk of loan default, and so lending standards loosened to the extent that the no-document loan was created, where the lender didn't ask for any information on the borrower at all. Inevitably with such lax lending practices the default rate began to rise, which precipitated a slump in house prices, which in turn led to more defaults. The monster created by MBS reached its nadir with the near collapse of the US financial system.
The term ‘toxic asset’ was first applied to MBS. Needless to say, investors in them suffered horrendous losses.
This however, is not quite the end of the moral of this story. Turning lemons into lemonade, a hedge fund was launched in 2008 to take advantage of the collapse in prices of MBS - in the first 5 years of trading it returned over 500 percent. Buying ‘toxic assets’ was of course considered highly risky, but the price was right, as the payoff so proved.
Within the financial services industry, risk categorisation is conveniently determined by the asset class e.g. stocks=high; bonds=low. But as in the example of MBS, when fortunes were lost when they were classed as low risk, and fortunes made when they were deemed to be high risk, the reality is often less clear-cut.
The Aspire solution is to view risk as being dynamic, rising with optimism and falling on pessimism. Contrary to the convention that encourages investors to expensively buy safety at the bottom and risk at the top, our view leads us to buy safety at the top and risk at the bottom - when both are at their cheapest.