Is Your Concept Of Risk Wrong?

January 25, 2017

Is Your Concept Of Risk Wrong?

  • Risk is an elusive concept. I’ll describe the various characteristics of it.
  • I firmly believe that low risk is related to high returns and high risk to low returns, just add an often-disregarded factor in investing – price.
  • We’ll conclude with investing options that lower your risk and increase returns.

Introduction

In order to be good investors, through economic cycles and stock market booms and busts, we should first focus on risk and only then on potential rewards because it is much easier to create long lasting positive returns if you can avoid losing money.

At the moment, the majority of market participants look at the stock market as if it is destined to only go up because stocks have historically had the best returns and the pain from the last financial crisis has been quickly forgotten.

There are two main reasons most market participants avoid thinking about risk. The first is greed: it is much nicer to focus on the positives, like potential rewards and dividends, than on risk. The second is that most market participants don’t understand the concept of risk because the definition of risk in the financial environment is somewhat elusive. Therefore, let’s first discuss what risk really is and how it should be defined.

The Definition Of Risk

99% of the financial establishment defines risk as the chance an investment’s actual return will differ from the expected return. That risk is measured with standard deviation where a high standard deviation indicates a high degree of risk and vice versa.

Two often used risk models like the Beta Coefficient and Value At Risk models are based on standard deviation. Both models use past data to determine future risks and then give you a probability for profit and loss.


Figure 1: Value at risk model description. Source: Wikipedia.

The issue with such models is that you can easily manipulate data to present the assets as less risky. Let me show you on an example of the S&P 500.


Figure 2: S&P 500 in the last 7 years. Source: Nasdaq.

If I asses the risk of investing in the S&P 500 through its standard deviation in the last 7 years, the risk of investing in the index is minimal as the standard deviation was very low. In addition, it looks like a great opportunity as the top and bottom red lines suggest the upside seems larger than the downside. The above model is a simplification, but it grasps the concepts used for assessing the risks of dotcom stocks in the 1990s and CDOs before the Great Recession because there were no historical precedents.

However, looking at the S&P 500 from a 20-year perspective we can see that the S&P 500 has enough historical precedents and the standard deviation is much larger.


Figure 3: S&P 500 in the last 20 years. Source: Nasdaq.

From a longer-term perspective, the potential loss from investing in the S&P 500 is more than 50%. Most investors prefer the shorter-term analysis of risk while the longer term is mostly left to boring hedge fund managers who have underperformed the S&P 500 in the last 6 years because they think too much about risk.

The above leads to another concept related to risk that many don’t rightly understand.

The Concept Of High Risk – High Return & Low Risk Low Return Is Flawed

In the financial world and academia, the concept taken for granted is that the higher the risk is, the higher the potential return is and vice versa. I find the concept completely flawed because, first, I don’t estimate risk through volatility (standard deviation) and secondly, when the risks are highest according to standard deviation models, it seems that they are in fact the lowest because there is no other way than up for the stock market. What determines your return is never risk but something much simpler, price.

If the S&P 500 falls by 40% from its current point, most market participants would start screaming about how the market is risky because of increased volatility and uncertainty which increase standard deviation. I, however, would see the market as simply much cheaper than it was and would expect higher returns in the future as stocks have a lower starting point while their businesses in the long term will operate equally.

This leads us to a concept of risk not used in academia and mainstream finance but that always occurs for those who beat the market for extremely long periods (Buffett, Klarman, Dalio, Lynch).

How Much Can I Lose In The Long Term? Risk According To Fundamentals 

A different approach to risk would have you look at the long-term performance of a business, and compare that to its current price, market environment, and outlook to tell you how low a stock can go and what the risk of a permanent loss is. An example is the pharmaceutical sector, considered by many to be the safest investment a year and a half ago.


Figure 4: iShares U.S. Pharmaceutical ETF. Source: Nasdaq.

At the moment, the pharma sector is considered risky because of negative sentiment and increased standard deviation. However, the medications people use, prescriptions, etc., haven’t changed at all aside from the usage which has increased in the last year and a half. Perhaps prices are a bit lower, but the long-term story remains intact. You can read more about how to approach risk from a fundamental perspective in the pharma sector in our article available here.

Another example is the S&P 500. The best returns in the last 10 years have been achieved by those who invested in the worst period: late 2008 and early 2009. At that time, stocks were considered the riskiest investment due to future uncertainties and high volatility, however they were also extremely cheap.

Think about your approach to stocks the next time a correction or a bear market comes along, if you are willing to buy the S&P 500 at above 2,200 points, I imagine you would be more willing to buy it at 1,600 because it would be cheaper. Unfortunately for the masses, and fortunately for those who understand how the market works, very few people think this way because of the incorrect concept of risk they have. It will be extremely difficult to change that concept as its roots are deep into the academic world which later translates into the practical world where the same flawed models are used over and over again.

Black Swans

Another concept of risk that can’t be included in a model, is a black swan. The concept was popularized by Nassim Taleb in his book “Fooled by Randomness” where he describes a black swan as a rare event that has extreme impact in retrospective, but not prospective predictability.

An example of a black swan would be a default of the U.S., unforeseen consequences coming from a halt in global trade that leads to a global recession, or simply hyperinflation.

At this moment in time, nobody is contemplating hyperinflation, but it would be a black swan event. It’s difficult to predict, the impact would be significant, and in hindsight, the occurrence of hyperinflation would be easily explained as a result of loose monetary policies around the world.

When a black swan comes along, all the assumptions that keep the financial world stable fall and new assumptions are created, with huge repercussions on asset prices. The funny thing is that black swans happen all the time. Recent examples of a black swan are the dotcom crash, and the fall of Lehman Brothers as those are both easily explained in hindsight but the large majority of the financial world didn’t see them coming at the time.

I don’t know what kind of black swan awaits us in the future, but I am sure there is one in the making and it can’t be predicted by standard risk measures.

Conclusion

I hope to have given you a different perspective on risk. At the moment, the S&P 500 has a dividend yield of 2.01% and an earnings yield of 3.92%. The yield is extremely low from an historic perspective and according to the mainstream explanation of risk, stocks should carry little risk. However, the opposite is true. At the moment, stocks carry a low return for extremely high risk. Bonds are in a similar situation.

Now, you could just follow the crowd, say that you’re a long-term investor, and not care about a possible decline. Trust me, 95% of those who approach investing with such an attitude will go into panic mode if a recession or a bear market hits us.

The other approach, one that requires more effort but also leads to higher returns with lower risks, is to position yourself with an all-weather strategy. This strategy includes:

  • Equities: Yes, but where fundamentals give a long-term margin of safety, even if the economic climate changes. More about such stocks here.
  • Bonds: Wth the yield so low, inflation rising, and the FED tapering, it looks like yields will go up. Therefore, it is better to hold cash than bonds at this time. More about bonds here.
  • Commodities: There are commodities that are becoming scarce and in the long-term, supply gaps will open. Plus, they protect you from inflation. More here.
  • Options: There are ways to protect your portfolio or increase its yield without taking more risk. More here.
  • Currencies: Macroeconomic currency values move in cycles, therefore international diversification at the right moment in time can increase your returns and lower your risks. Keep reading Investiv Daily for upcoming articles on how to seize currency opportunities, and much more.