Does Higher Yield Really Mean a Higher Chance of Loss?

September 8, 20163 min read
Does Higher Yield Really Mean a Higher Chance of Loss?
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Traditionally, experts have explained investing to their clients in an oversimplified way – the idea that higher risk equals bigger rewards, while less risk gets you less of a return. At a very broad level, that’s true– but it doesn’t really paint the whole picture.

In general, taking more risks can lead to bigger yields on equities and other investments. That’s why many financial advisors suggest taking on a lot of risks as a young investor (when you have more time to ride out markets) and decreasing risk in a 401k or IRA as a career pro moves toward retirement.

This principle is evident in the bond market: safer bonds have lower returns, and very risky bonds (often called “junk” bonds) come with enticing high-interest promises. The investor is getting a bigger potential payload against the higher risk of default by the borrower.

Another investment option that people tend to see as risky and volatile is alternative investments. Alternative investments are those that don’t fall into one of the most common boxes: equities, bonds, or easily traded funds.

So are they safe?

As it turns out, there are ways to increase yields without taking on additional risk.

At Yieldstreet, we try to take advantage some of the elements of investing that don’t necessarily create more risk.

For example, take liquidity risk – that’s the idea that by keeping your money in an investment for a longer period of time, or accepting less desirable payout terms, you get more eventual yield. Currently all Yieldstreet offerings will lock capital for one to three years depending on the investment duration.

We also talk about something else that we call “inconvenience risk” – this is the idea that there may be delays to a given resolution, like a payoff from a completed project. The potential for delay can be tied to bigger yields – because the borrower is asking for greater flexibility regarding a set of outcomes. For example, we can estimate when different legal cases may settle, but cannot guarantee a payment date.

Another factor is the frequency of payments in a payout schedule. In some cases, investments that pay out less frequently will compensate the investor for the length of time that the money is tied up. Again, the investor, as a lender, is getting compensated for things that, while inconvenient, don’t raise risks. It is important to note that liquidity risk, inconvenience risk and frequency of payments don’t increase chances of defaulting, or lessen the chance that a particular gain is going to happen. They just change the timeline or potentially make a project more complicated.

There’s also a set of strategic considerations when looking at risk, like “concentration risk.”  In many ways, concentration is the opposite of asset diversification. By diversifying a portfolio, investors try to minimize their risk by spreading throughout their portfolio. They can hedge against a risky position, or spread money around to decrease the chances that the basket of investments will take a big hit all at once. Concentration risk involves having a smaller portfolio of assets (for example, in real estate, think owning 3 properties instead of 10.)

Higher-yield loans are considered riskier than loans that target much lower returns, such as corporate bonds. The comparatively higher risks presented by these investments are set forth in detail in the offering documents listed on the offering page, with many bearing on the ability of a given borrower to pay back the loan according to its terms. Yieldstreet seeks to minimize that risk, for example with asset-backed collateral and sometimes personal guarantees, again as described in the offering documents prepared for each investment.

All of these are mitigating factors in yield. Some elements of an opportunity add to risk; others don’t. It’s important to be clear-eyed about the risk that you take on, and to strategize about how you can minimize any risk that does exist. Any investor needs to be clear about his/her appetite for risk, so that regardless of how things work out, they can be confident in knowing the rules of the game, and ready to try again.