Market Musings Blog

Risk is inextricably tied to return. It is not true that taking higher risk means you will see higher returns, What is true is that higher risk raises the probability that you will harvest higher returns. It also raises the probability of losses (see our last post).

Part of any investment manager’s job is to gauge the potential risk of an asset. If you accept a ‘lock up’ on an investment preventing you from selling it for a time, risk increases. If debt is used to finance the asset, risk increases. If operating results are lousy, risk is high. If an investment has multiple partners, risk can be high depending on entity structure. Merging companies present risk, even building a new plant can be risky. Once you identify sources of risk, the next rule is to get paid for accepting that risk.

You can’t know what future returns will be, but many assets offer clues. A stock that pays a 6% dividend yield when everything else is yielding 3% is probably riskier than normal, but that upfront payment is a good start towards a healthy return – if the payout can persist. Real estate investments that offer net cash flow of 3% or 4% in addition to future rent increases and modest appreciation; bonds that sell at a discount and also pay cash flow of 5% to 6%; private equity investments with ever growing valuations at each new investment round; these are examples of assets that could deliver above average returns.

What’s ‘average’? We benchmark most assets to long term stock returns, which are roughly 9.5% per year since 1926; bad years can shave 45% off your portfolio value. If you are taking stock-like risk in some exotic asset, with potential losses on the table, there had better be a potential return above 9.5%. Bond returns since 1926 – using intermediate corporate issues as our benchmark – are between 5% and 6% per year on average; bad years are not really very bad in the bond department, with losses only amounting to about 5% in the worst year for these maturities. If you finance a real estate development for your buddy, you are essentially issuing a private bond, and you’d better insist on more than 6%.

Using comparisons to historical returns and losses lets you approach risk with eyes wide open.

Countless words have been writ about risk. The topic grows in popularity when markets crash (avoidance), and fades when markets rise. Then, when markets hit new highs, risk becomes popular in another way – people embrace it.

Most of the definitions of risk are of limited usefulness. Technical definitions talk about volatility, components of return, and so forth, but depend on assumptions that can blow apart when markets change suddenly. Meanwhile, the media has brainwashed investors into believing that taking more risk means more return.

It’s not that simple.

What does risk really means to the lay investor who has limited funds and is trying to achieve or maintain a certain lifestyle with his investment program? We explain it this way: risk is the possibility that you will have to make a change to how you live your life in the short term in order to obtain a certain goal in the long term, ‘long term’ being perhaps useless to you in that it exceeds your lifetime. In other words, you could be forced to make a short term sacrifice to no good end. This is the ‘losing’ side of risk, and it happens every day.

An investor who has a portfolio allocated 50/50 between stocks and bonds wants ‘more risk’ now that the market is up but also wants to retire in five years or less. He thinks that increasing his risk will get him to his goal faster. Instead, moving to 70% stocks increases the probability that he will not achieve retirement in even five years. If the market corrects like it did in ’08/’09, it could be five years before he’s recovered his value, let alone earned more.

Higher risk is not consistent with short term goals. Those goals must ‘give way’ to achieve the longer term benefit.

Stay tuned for our next entry, which will discuss getting paid for the risk you are taking.

This week, JP Morgan Chase revealed that hackers invaded its customer records. On the heels of that announcement, many banks assured customers that ‘security is important to us’. No doubt. The problem is that the evolution of hackers is just a fast as, if not faster than the evolution of defenses. Someday, hackers may not simply steal your social security number or account records. They will steal your money too, right out of your bank account.

You’re thinking that your deposits are insured, right? Aha, that is true, but only in the event of bank failure. Theft is not covered by FDIC insurance. Certain types of terrorism insurance exist, but exactly what they cover is somewhat open to interpretation. There’s no question that if a large bank were swept clean of deposits, its insurer would claim that the event fell outside the coverage in the insurance contract. In the meantime, there you are, with no funds.

The best defense is a good offense. It might be time to ask your bank exactly what happens in the event of a security breach that brings your deposit balances to zero. We don’t advocate any bank over any other, but put yourself in the hacker’s shoes: if you were reaching for the brass ring, wouldn’t you go where the money is – ie, the biggest bank you could reasonably hack? You probably would not bother with a small community bank. On the other hand, does your community bank have the resources to stand up to cyber crime?

We have the uneasy feeling that the various hacks, identity thefts, data breaches, and so forth over the past several years are practice. Eventually someone somewhere is going to figure out how to make a massive funds transfer from a very large bank. Better hope it’s not yours.

In a word, no. But stocks could rock and roll for a while. Geopolitical considerations have finally seeped into investors’ collective conscience, perhaps by dint of sheer number and degree of horror. Earnings have been pretty good, but the economy retains its ‘fits and starts’ feel. Confidence is sliding for the time being.

In times of high uncertainty, investors push asset prices down until they feel better about values. Stocks may be headed there for the time being. We don’t expect this to amount to more than the every-calendar-year 5% to 10% correction that’s normal throughout history, but it might be a good time to pare back any positions you think are overvalued.

One of my favorite horse trainers had a great saying. When shown a big, elegant, young jumper prospect, he would say ‘pretty is as pretty does.’ One of his most successful jumpers was a jugheaded, roman-nosed horse whose front legs ‘looked like they came out of the same hole’ as he put it. But that horse could jump the moon.
Still, his clients liked the pretty horses that were nothing but trouble. The world just works that way. Our stocks are inelegant to the extreme and often belong to the ‘old economy’. Clients often wish we owned Facebook and Tesla.

The same thing applies on a larger scale. We operate in the simple realm of stocks, bonds, cash, and for some, real estate. Private equity, hedge funds, currency and commodity funds are constantly sending out their siren songs in the media. First this one is ‘hot’, then that one.

But ‘pretty is as pretty does.’ Recently, the Wall Street Journal published an article, “Big Investors Missed Stock Rally”, detailing how large pension and endowment plans, because of increased allocations to ‘alternatives’ and away from plain vanilla stocks, experienced much reduced returns over the last few years as a result of those allocations. Granted, the funds’ ten year returns were buoyed by alternatives because of less volatile performance in the ‘08/’09 period. But that lower volatility could have easily been achieved with government bonds, one of the simplest, cheapest investments available.

We’ll stick with contrarian strategies that deliver controlled volatility and inches of incremental return over time, rather than miles of return at the cost of big swings in portfolio value.