Overview – Understanding Asset Safety
When looking to purchase assets for investment purposes, investors have all sorts of criteria they look at, both quantitative and qualitative, to help justify their decisions. Of all the different variables that must be weighed and carefully analyzed, there’s one question that crosses some investors’ minds at least once: “is this asset something they’d consider to be ‘safe'”?
Now, in the context of investing, “safe” can take on many different meanings depending on who you ask – some investors may argue that an asset’s safety is its claim on a company’s assets, some may define it as an asset’s ability to consistently deliver value, whereas others may say that a “safe” asset is one that doesn’t experience a sharp decline in value in the blink of an eye.
While these various definitions certainly have merit, what we’re looking for is something that connects all these definitions, and how that single unifying factor can be used to determine the safety of a given asset. In this article, we will be exploring just that.
What is an Asset, Anyways?
Before continuing, we must first answer a fundamental question: what exactly is an asset?
The problem with defining an asset is that the definition depends very heavily on the context it’s used in. For example, a business may consider its vehicles and computers as assets, while a person who uses the same items for personal reasons may not view them as such.
For our purposes, we will limit our discussion solely to financial assets. A quick google search shows that a financial asset is defined as “a non-physical asset whose value is derived from a contractual claim, such as bank deposits, bonds, and participation in companies’ share capital.”
So, a financial asset is a non-physical object (stocks, bonds, options, derivatives) that derives its value from some sort of underlying mechanism (in the case of financial assets, an implicit contract between two parties: the buyer and the seller). This contract will usually be set up in such a way that both parties stand to benefit in some concrete way.
A popular tool to help clearly showcase a financial asset’s safety is by creating a sort of hierarchy. While the intention is certainly noble, the problem with creating such a hierarchy is that the underlying philosophy behind it is fundamentally flawed.
The Financial Asset Hierarchy, and the Problem Behind It
Financial assets, broadly speaking, can usually be split into two major groups: debt instruments and equities. We’ve previously gone over the differences between debt instruments and equities in another article.
In that article, we also looked at how, whether you own equity or a debt instrument, investors also have a contractual claim on a company’s assets in the event of a liquidation. Based on who gets compensated first, this order leads to a certain hierarchy, which is shown below:
Based on this hierarchy, investors and investment pundits alike love to point at bonds and proclaim how “safe” they are because they are the first in line to receive a company’s assets in the event of a liquidation.
On that same note, many people are quick to say that stocks (more specifically, common stocks) are risky simply because they are the last in line to receive anything, coupled with the fact that their prices are more susceptible to volatility (more on this later).
It has gotten to the point that some people have conflated this hierarchy of the claim on assets with a financial asset’s safety. For example, some people are very quick to say that bonds are automatically safer than stocks, but their reasoning for this “safety” may simply be the claim on a company’s assets and not the safety of the financial asset itself (more on this in the next section).
Although this hierarchy accurately represents which investors will get compensated first based on the type of financial asset they own, the major assumption being made is that the liquidation process will go smoothly. Put another way, this hierarchy is only true if every bondholder gets fully compensated, then every preferred shareholder thereafter, and so forth.
Being the first in line to get compensated as a bondholder sounds great, but if the company doesn’t raise enough funds to compensate all its bondholders, then being first in line won’t mean anything if you aren’t going to receive the full amount you’re owed, if anything, at all.
There’s nothing “safe” about standing ahead of others, only to find out that nothing awaits you. Therefore, a different definition of asset safety is needed, one that doesn’t simply look at who gets compensated first.
A Different Look at Asset Safety
In The Intelligent Investor, Benjamin Graham challenges the notion that bonds are inherently safer than stocks. Most investors understand how bonds work: they compensate bondholders by paying them routine interest payments and will repay the principal once the bond has reached maturity. Because of this, the logic some investors follow is that bonds are safe simply because they are bonds – in other words, their safety is derived from their form.
Graham argues that the safety of a bond isn’t determined by its form, but rather by the ability of the bond issuer to repay the principal in full and make interest payments on time.
Government bonds are popular amongst defensive investors for their reputation of hardly, if ever, defaulting (assuming you purchase government bonds from an advanced economy). However, if a government issues bonds and is unable to repay the principal, then that bond is essentially worthless because the contractual obligation that gives the bond its value in the first place cannot be honoured.
Therefore, another way we can define asset safety is the ability of a financial asset’s issuer to successfully honour the underlying contractual claim that gives the asset its value.
This notion of a contractual claim serving as the source of value of a financial asset was brought up earlier. If that contractual claim has a high risk of being jeopardized, then it should follow that the asset also poses a high risk to the investor, and vice versa.
It’s entirely possible for an investor to have a portfolio comprised mostly of equities and for it to have low investment risk. How is that possible if conventional investment wisdom says otherwise?
We know that the contractual claim behind equities is that, in exchange for giving a company some capital, investors become partial owners of the company, and as a result, are entitled to a portion of the company’s profits (by way of dividends) and/or an increase in the value of their ownership stake (i.e., capital appreciation).
If the issuer of a given equity can successfully honour this contract and have a proven history of doing so, then investors can rest easy knowing that the equity they own is safe.
Similarly, it’s also possible for an investor to have most of their portfolio tied up in bonds yet still pose a very high risk. How? Again, the answer to this lies in understanding the contractual claim that underpins a bond’s value.
In exchange for giving capital to help the bond issuer repay a debt, bondholders have a contractual claim to receive routine interest payments and their principal back after a set amount of time. If this cannot be honoured, then bondholders are at risk of losing their capital.
A financial asset’s safety is only as good as the strength of the contract behind it. If the contract cannot be honoured, then the value disappears along with it, meaning investors stand to lose their capital in the process.
Differentiating Between Asset Safety and Volatility
Another interpretation of asset safety that some people have in mind is that a “safe” asset is one that doesn’t experience wild price swings. In other words, an asset is deemed safe if it’s immune (or at least, minimally affected) by volatility.
Going back to our discussion of stocks and bonds, once again some pundits are quick to label stocks as “risky” because of their susceptibility to major price swings, whereas bonds are considered “safe” because their prices don’t experience such major swings.
The problem with using an asset’s price movements as the basis for judging its safety is that there are countless variables that affect asset price, some of which can be controlled, and others that are simply left to the whims of luck and circumstance. Not only that, but wild price swings are usually the product of short-term mayhem, and very few, if any, assets are spared from this frenzy, regardless of how strong they are.
A classic example is the equities market before the COVID pandemic. Before the pandemic struck, many publicly traded companies were humming along just fine. However, once the pandemic was declared, the stock prices of many companies tanked seemingly overnight.
While many companies were certainly affected by the pandemic and all the series of events that followed, this wasn’t true for many others. Despite the sudden hit in stock price, many companies could still honour the contractual obligation that their stock promised. Sure, prices varied wildly for a time, but the underlying contract of many stocks largely remained unaffected, meaning their safety also stayed intact.
Many investors are quick to sell excellent investments simply because they’ve displayed a bit of volatility, yet fail to stop and assess whether the underlying contractual obligation that a particular asset is backed by can still be honoured.
Why All This Matters to Investors
Many investors are quick to shy away from certain financial assets such as stocks and options simply because they are viewed as “risky”, yet are equally as fast to flock to “safe” assets like bonds or GICs. Why is that?
As we’ve discussed, the reason may be that they mistakenly believe that the safety (or danger) of an asset is due to its form, or its ability not to be affected by major price swings, and not the strength of its underlying contractual obligation.
Because of this misunderstanding, certain consequences may arise, such as investors inadvertently limiting the types of investments they choose to pursue, missing out on higher returns they’re capable of achieving, or failing to adequately diversify their portfolios out of fear that they’re taking on “riskier” investments in the process, to name a few.
Imagine foregoing the chance to pursue excellent investment opportunities or missing out on potentially higher returns just because you misunderstood what constituted a “safe” versus “dangerous” asset.
Any sensible investor doesn’t want to see the money they put down for investment purposes evaporate in the blink of an eye, so it’s understandable that they want to ensure that the assets they own for investment purposes don’t present that possibility, or at least have the smallest possible chance of doing so.
That being said, misunderstanding what asset safety entails can be just as detrimental as taking on too much risk, leading investors to make decisions that, although may seem sensible, can potentially hurt them down the line.
Wrapping Up
Investors look at all sorts of variables when looking to purchase assets for investment purposes, and one question in particular that’s bound to cross the minds of some is: “is this asset safe?”
This isn’t an unusual question to ask, after all, no investor wants to tie up their money in an asset only to end up losing it. In that case, what constitutes an asset’s “safety” in the first place?
When looking specifically at financial assets, their value is derived from an underlying contractual claim between the buyer and the seller. The seller receives capital, and in return, the buyer receives some sort of future return. As long as this contract can be honoured, then investors can be assured that their capital is safe.
Some investors believe that an asset’s safety is determined by where they stand in terms of compensation in the event of a liquidation, or how resilient an asset’s price is to the effects of volatility. However, being the first in line won’t mean anything if there’s no compensation that awaits you, and price volatility doesn’t necessarily mean the underlying contract has been compromised.
Misunderstanding what asset safety entails can lead investors to all sorts of unintended consequences, some of which may impact them quite severely.
