This Is How You Should Look At Risk

December 20, 2017

This Is How You Should Look At Risk

  • Something that has just increased in price isn’t considered risky, but something that decreases is.
  • Further, something that isn’t volatile is also not considered risky.
  • I’ll discuss perhaps the most important currently overlooked factor in investing, risk.



Introduction

A recent Wall Stree Journal article discussed how 2017 was a bad year for Chinese IPOs.

On aggregate, China’s 2017 IPOs created a negative 5.7% return and more than half of them produced negative returns of over 10% where 10 of the 16 stocks still trade below IPO prices.

The article continues by describing how the reason behind such a performance is the relatively high price to earnings ratios at which the companies went public. The historical average for Chinese IPOs has been 30, but went up to 50 in 2017.

Figure 1: The stocks WSJ picked to show bad performance. Source: WSJ.

As you can see in the figure, some stocks even fell 40% which immediately labels the sector as extremely risky. Phrases like “short term bubble” are used and it’s logical that investors’ sentiment is negative toward such stocks as many fear more losses.

This all leads to another very important discussion and one very few understand. In investing, just because risks often don’t materialize it doesn’t mean there aren’t any.

Chinese IPO stocks are now considered risky, but the S&P 500 isn’t considered risky because it has gone up almost 20% year to date.

Figure 2: S&P 500 year to date. Source: CNN Money.



To the untrained eye, the S&P 500 seems much less risky than the stocks described in figure 1. However, if we look at valuations, the price to earnings ratio of the S&P 500 is at 25.72, which is 75% higher than the historical median. The valuations of this year’s Chinese IPOs have been just 66% higher than the historical average of 30.

So apart from performance, there isn’t a big difference between between the two which doesn’t mean that one is riskier than the other. Further, risk is measured through volatility. The current volatility of the S&P 500 is at historical lows which implies the S&P 500 carries very little risk.

Figure 3: Historical VIX index. Source: CNBC.

Now, my point is that many look at risk from the perspective of past performance or volatility which are both erroneous. The only way to look at risk is to ask yourself this question: what is the potential for permanent capital loss or the possibility of not achieving your required investment returns?

Permanent capital loss describes a situation where there is no other option than to accept a loss from an investment by either selling it or never seeing it recover above the price paid for it. The possibility of not reaching required returns describes the possibility that you don’t receive the expected return in relation to your investing goal.

Now let’s look at the risk of the S&P 500 from this perspective.

The risk of permanent capital loss is dependent on your investing horizon. There is a high probability that the S&P 500 returns to the historical valuation mean given higher interest rates. If that happens and we see an environment that is similar to the 1950 to 1980 period, we could see a lost decade or perhaps even a few lost for the S&P 500.

As for the possibility of missing the required returns, given the possibility of loss the S&P 500 offers, perhaps it doesn’t manage to deliver 4% yearly returns over the next 20 years. This would have a very negative impact on those who expect to retire in this period who really need stocks to deliver at least 4%.



Now, I’m not saying that fintech Chinese IPOs are less risky than the S&P 500, but my point is that everyone should know how to estimate risk which is a function of price first. The higher the price is, the higher the probability for permanent capital loss and not achieving a satisfactory return is.

Secondly, the higher the valuation in relation to growth, the higher the risk that a change in interest rates will negatively impact your holding.

I’ll conclude today’s article with the message that risk shouldn’t be estimated through past performance, as many measure it. Instead, the higher the price is, the greater the risk is.

The S&P 500 is at least 20% riskier today than it was a year ago, while the Chinese stocks that have fallen 40% since IPO are much less risky than they were at their IPO.

© 2017 Investiv

By Sven Carlin Investiv Daily Risk S&P 500 Share:
Search