Risk for Airplanes (Part 1)
Howard Marks, of Oaktree Capital fame, has spent a lot of time writing about how risk is an integral component of portfolio construction. His extrapolation on the use of volatility when measuring risk, especially as it relates to constructing a defined portfolio using Modern Portfolio Theory, has changed the way many people view risk and how to effectively work with it.
His contention is that riskier assets do not necessarily produce greater returns (figure 1). Instead, riskier investments produce a wider range of potential return outcomes that can be described using a probability distribution (figure 2). For simplicity’s sake, a bell curve can be used with a mean value equal to the return expectation at that risk level. The use of a bell curve ensures that there is no change to the methodology used in Modern Portfolio Theory, but gives investors a more realistic way to imagine how their investment decisions can impact their future position.
As can be seen, as the risk of any given investment rises, the proposal is that instead of just a higher return, the investor is instead going to experience a wider array of potential outcomes for their investment.
It is important to note that this is not a discussion of volatility. Although traditional volatility is derived in a manner similar to this, traditional volatility is a time dependent function. This argument is independent of investment time frame.
From our experience, Mr. Marks’ observation proves to be truthful, and often overlooked. While investors have come to understand the importance of using volatility to make smarter investment decisions, their overlooking of the actual implications of risk vs. reward has caused many people a lot of suffering.
You’re probably wondering, however, what this has to do with airplanes. Gemco is fundamentally an aviation company, so this article should be related to your aircraft’s operation. The bridge that will connect everything together is this concept of risk, and how we work with it as we operate our planes.
Aviation is one of the more expensive hobbies you can be involved in. When I had just got my Commercial pilot’s license and was dreaming of bigger things, I was dating a girl that was an avid equestrian. I joked that together we might have the most expensive hobbies in the world. As I learned, if anything can challenge the expense of aviation, horses might be able to do it. I’ve heard people try to defend that aviation is not that expensive, and that with a little creativity anyone can afford it. Maybe. But affordable aviation has drawbacks that makes flying so impractical that for many it is not worth being involved in.
In a world where new aircraft cost more than the majority of American homes, and where used aircraft cost more than the average American’s yearly salary, they are just as must investments as they are flying machines. So if you have already made the determination to own or operate, it behooves you to start taking the appropriate steps to start managing your risk appropriately.
Every owner has an idea of the risks that they face when owning an aircraft. Any liability is a type of risk, and these can manifest themselves in the form of scheduled maintenance, unscheduled maintenance, and inspections. We’ve already written heavily on the considerations you need to make concerning liabilities, and how they play into your everyday operation. However, there is more risk that usually comes in “under the radar” when it comes to ownership.
The largest of these is Underperformance Risk. Even if you have the best plan in the world to meet the liabilities of aircraft ownership and operation, the possibility of changes to the operating environment can alter the financial stability of your situation. For example, if inflation decides that it wants to start on a tear, how will your plan function? Inflation has been historically low for years following the recession a few years ago. You cannot expect, however, for it to remain at these historically low rates.
The best way to look at this is via a practical situation. If you’re a smart owner who has taken the liability of your next overhaul into your own hands, you may have started saving as soon as practically possible. To help generate some returns on your sitting reserves, you probably invested them in a stable account such as a CD, government savings bonds, or maybe some investment grade corporate debt. If interest rates skyrocket up to 6% from the current 1.7%, you’re in trouble and very susceptible to underperformance risk because of your exposure to more fundamental risk elements:
- Interest Rate Risk – Your investment is probably structured to hold a variety of diversified bonds with high credit ratings. This ensures the safety of your initial reserve capital, but at the expense of the possibility of generating large returns. If inflation spikes, your return on investments could be below the new rate of inflation. When inflation is greater than investment return, you lose buying power if you do not take any action.
- Illiquidity Risk – Your structure might be the best way to maintain your initial reserve capital, but if the inflation rate rises to the 6% hypothetical future value you will struggle to find an buyer who is willing to buy it anywhere near the face value price. To compensate for the below average returns, you will be forced to sell your bond at a discount to the face value. If you decide to sell in this scenario, you will lose your initial reserve capital because of market liquidity issues.
These two factors, when paired together, form a specific type of elasticity risk. This elasticity risk forms one of the most potent factors that drives under-performance risk. It is also one of the most under recognized risks among investors.
Holding the investment means their money is losing value, while selling poorly performing assets can result in an immediate loss of reserve equity because of liquidity issues. Riding out the storm, which would appear to be the only option, would expose the owner/operator to under-performance risk.
If the owner decides to hold course by accepting an interest rate below the inflation rate, they will find that they do not have the capital available to them at the time of overhaul. Nothing escapes the freight train of inflation, aircraft engines included. That engine that costs $30,000 today will cost $40,000 in the future. Not keeping inflation in mind will always leave you short changed.
On the other hand, by accepting a price below par value for a bond because of liquidity issues presents a similar problem. Not only is the owner now on the hook for additional unforeseen transaction costs, they have sacrificed reserve capital, as well. If a plan is not in place to compensate for this loss of capital, the reserve account will not have the assets present to cover the future liabilities it was intended to address.
Under-performance risk is the risk can be described as an investment structure will fail to deliver the returns required of an investing party because of the impact of a variety of unforeseen factors.
There is no way to avoid risk when working in financial considerations. Instead, a smart investor needs to develop a plan to predict future risk factors, weight them, and make decisions to address the potential impact of each factor. Implementation of this, however, proves to be more difficult.
Continue to Part 2 ->