The Entire Risk Spectrum

In the investment world, there are literally thousands of different products you can buy. There are those that most people have heard of, like stocks and bonds. There are safe products like CD’s and US Treasury Bills. There are risky products like call options and futures contracts. There are those “less understood by the general public” products like mortgage-backed securities and volatility futures. Then there are those “less understood by the general professional investor public” like variance swaps and worst-of Bermuda options. (What could go wrong in Bermuda?)

The one common thread among all financial products is risk. Every single product out there can be ranked by its potential for loss. This note will take you through the entire risk spectrum, in order of smallest to largest potential for loss.

100% SAFE (0 potential for loss):

Nothing at all. Not even cash. Sorry to say it, but it’s true. The world financial system is predicated on trust, which gets tested every 10-15 years, and comes to the verge of collapse every 80 years or so. Most recently in 2008. Prior to that, 1929 was pretty bad. 1873 wasn’t pretty either. The list goes on. If we lose trust in the system it’s all over. *Cryptoheads have entered the chat.* We will ignore them for now.

In our centralized financial system, cash is king. We will rate it at 99.9% safe. It will lose to inflation, but we’re going to ignore that too. We need to ignore a lot of things to understand the basics because the money system never stops moving. If it does, it will explode, and it almost did in March 2020 because of Covid.

Extremely low potential for loss:

CD’s - Those brave souls willing to part from their cold hard cash and trust a bank to hold the money for an agreed upon period of time will be rewarded with an interest payment. Formally, this is called a Certificate of Deposit, or CD. Even if the bank goes bust overnight and doesn’t have the money to pay you back, you are insured by Uncle Sam via the FDIC for up to $250,000. CD’s used to be a safe source of income in the ‘80s and ‘90s. In 1981, you could buy an insured 3-month CD that would pay you 18%. Today they are equally safe, but provide virtually no income. The best 3-month CD pays an ...