Risk is the "permanent impairment of capital"

Risk is the "permanent impairment of capital"
Wealth manager reflects on how alternatives arose from turmoil.
OCT 25, 2024

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group traces the origins of alternative investments, noting that many of these trends are born from moments of market turmoil when investors lose confidence in traditional avenues like Wall Street.

"If you start in 2000 in that era, hedge funds were an emerging trend in alternative investments," he tells IN. "They like the hedging part of it – but they didn't like hedging when the market was going straight up. They liked going down."

This shift in investor sentiment is a pattern Chisholm has observed repeatedly over the years, where alternative investments rise in popularity as a response to market uncertainties, only to become less attractive as conditions stabilize. The cyclical nature of these trends is a key theme in Chisholm’s analysis. After hedge funds, other asset classes like managed futures had their moments in the spotlight, only to be "watered down" as more investors flocked to them.

“Private equity is the thing now," Chisholm says. And also private credit is an up and coming, new trend and alternatives.”

However, Chisholm draws a clear distinction between the trends in Wall Street’s alternative investments and those on the private side. The private side, which includes investments like real estate and private mortgages, tends to be more stable and less influenced by market fads.

"Real estate investors tend to be real estate investors, private mortgage people tend to be private mortgage people," he explains. "On the private side, people tend to be who they are... they tend to kind of move around in different parts of that.”

When it comes to managing risk, Chisholm offers a pragmatic and disciplined approach. He distinguishes between risk and volatility, terms that are often conflated by investors.

“People look at risk management and they confuse it with volatility management," he says, clarifying that while volatility refers to the short-term fluctuations in asset prices, risk is more about the potential for a permanent loss of capital.

"Risk is, I would define it as a permanent impairment of capital," Chisholm explains.

Chisholm advocates for a structured approach to risk management, which he breaks down into a three-step process: "identify all the risks, mitigate as many as possible, and being comfortable with what's left over."

And this method is applicable across various asset classes and investment strategies. For instance, in real estate, risk management might involve conducting thorough due diligence on a property, ensuring adequate insurance coverage, and carefully selecting tenants.

"That's management of risk," says Chisholm.

Another area where Chisholm offers valuable insights is in the use of self-directed IRAs (Individual Retirement Accounts). These accounts allow investors to hold alternative assets within their retirement portfolios, providing a level of flexibility that is often underutilized.

"Technically all IRAs are self-directed," Chisholm tells IN, though the term is typically used to describe accounts holding non-traditional assets like real estate or private mortgages. This flexibility is particularly appealing to investors who have specialized knowledge in certain areas and prefer to invest in what they know.

"Somebody who's a real estate investor, they could put real estate in their IRA," he adds.  

However, Chisholm also cautions that self-directed IRAs come with their own set of rules and regulations, which can be complex and sometimes counterintuitive. One of the key considerations is the concept of "disqualified persons," which refers to individuals who are prohibited from engaging in certain transactions with the IRA. This includes the account holder, their spouse, children, and other close family members.

"There are rules. There are exceptions to those rules, and there's exceptions to those exceptions," Chisholm says. "If you're trying to circumvent the rules, don't do it. It's not worth it." 

As concerns about inflation continue to rise, Chisholm offers a balanced perspective on how investors can protect their wealth. While he acknowledges that inflation is a legitimate concern, he does not see it as a major threat in the immediate future. Nonetheless, he recommends several strategies for those looking to hedge against inflation, particularly through investments in hard assets.

"Typical inflation strategies might be precious metals," he adds.  "Gold bought the equivalent of a suit in Rome thousands of years ago, and an ounce of gold, equivalently, will buy a suit in London.”

And Chisholm’s approach to inflation protection is rooted in a deep understanding of economic cycles and historical precedent. He emphasizes the importance of not only selecting the right assets but also understanding the specific economic environment in which one is investing.

"You just have to be really careful about what are we actually having? Is it inflation? Is it stagflation or something else?"

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