Uncertainty seemed to have benefited investors in 2013. However this hasn’t always been the case, especially in 2008. As recently released Federal Reserve papers show, it was a little luck and a great amount of risk that helped prevent a further decline in the stock market and the economy.
There is certainly the possibility that low interest rates may not stay low. While bonds are obviously susceptible to higher interest rates, real estate and real estate investment trusts (REITs) are also impacted by higher interest rates. Consequently, there may be a higher risk of losing money now due to the amount of money that has poured into these investments.
For example, the S&P 500 increased 29.6% in 2013. But as David Blitzer, managing Director and Chairman of S&P Dow Jones Indices states, “The result (of the increase in the S&P 500) was not assured; some predicted rampant inflation and collapsing markets would result from the same policies (quantitative easing, that seemed to increase the stock market in 2013).”
The idea of uncertainty in the stock market prompts a discussion of risk. What is it? How is it related to investing and how do we account for it when making investment decisions.
Risk – What Is It?
In the May/June 2014 issue of the Journal of Indexes, an article titled “Risk Factors: a Round Table,” by Heather Bell discussed risk and what it means for financial advisors and their investors.
Risk is generally thought of as three things:
- The rise and fall of prices, known as volatility
- Max drawdowns (how far a portfolio will decline during the worst moments)
- Permanent loss of value, also known as default
Volatility
Volatility often creates opportunities. However, for financial advisors working with clients, volatility is a nuisance because individual clients are often concerned about any decline in the value of their portfolio.
Ted Lucas, founder and managing partner of Lattice Strategies states that “volatility is perhaps the worst measure of risk, because all it does is describe the actual amplitude of price returns for an asset or a portfolio in the past.”
Over the last five years, we have not seen a consistent stream of volatility. Instead, with the exception of a brief market decline in 2011, prices have consistently risen, giving investors a false sense of security in the stock market.
Maximum Drawdown
Maximum drawdown is the accumulated loss of buying an investment at its highest maximum price and selling it at its lowest minimum price. Since 2009, the maximum drawdown in the S&P 500 has measured less than 20%. However, this masks the true potential that declined in value. The drawdown refers to the percentage change from the peak to the bottom.
Since the FED has printed money, the risk of drawdown seems to have been minimized. However, I view maximum drawdown as the second phase of a full market cycle. The first phase is the advance. As stock market analyst John Hussman has noted, the drawdown usually erases four out of five years’ worth of gains form the initial upswing.
Beginning in 2008, the S&P 500 was down 51%. From October 2007 through the end of February 2009, the Russell 2000 was down 52%, the S&P GSCI had decreased by 53% and the iShares MSCI Emerging Markets (ARCA:EEM) Index had fallen by 62%. Only government treasury bonds and managed futures seemed to survive and increase in value during that time.
Permanent Loss of Value
The last category that people think of when it comes to risk is permanent loss of value, otherwise known as default. This is what I believe Warren Buffett is referring to when he says there are two rules of investing 1. Don’t lose money, 2. Don’t forget rule number 1.
Vineer Bhansali, managing director and portfolio manager of PIMCO believes, “The real risk is a risk of permanent loss; the loss of capital, loss from default, loss from a tail event happening where you end up getting forced to liquidate at the wrong time.”
For advisors using indexes or DFA funds that are broadly exposed to the market, there is a very small chance that all investments will default or go bankrupt. Over time, prices tend to move higher, providing investors with an increasing amount of wealth.
Consequently, for most financial advisors invested in a diversified portfolio, the bigger concern is not the outright loss of money, but rather in dealing with clients who are concerned with volatility or max drawdowns.
Diversification
The key tool for financial advisors has always been diversification. However, in 2008, diversification failed. Over the course of 16 months, beginning in 2008, diversification seemed to seize operating and as a result, modern portfolio theory came under fire.
It may not have been diversification that was at fault. What really happened is that many investors diversified based on stocks or emerging markets in Europe. However, all of these investments were susceptible to the same risks. Most portfolios are not diversified, because most asset classes are highly correlated to each other.
Bhansali believes that “most people diversify only using underlying asset characteristics which is very limiting, because assets have a lot of underlying exposure.” Consequently, diversifying using risk factors instead of assets may be a better way to look at investing.
Tools
In the current world of finance, several tools have evolved to limit the types of risk that were defined above.
Futures, options and exchange traded funds with futures and options are tools that can help limit risk, but they are complicated products. Each acts differently and doesn’t track the market linearly, meaning that the products do not increase in value one for one when the market declines. Additionally, these products are expensive.
Futures and options can work when used appropriately and purchased at the right price. Some of the most straightforward ways to manage risk is to purchase investments when they are out of favor. This can be bonds, real estate, stocks options or stock indexes.
Investing in areas where others are not interested may be a good place to invest historically to guard against risk.
What Can a Financial Advisor Do?
To review, there are many risk factors that financial advisors have to deal with. Certainly the greatest risk is the permanent loss of money; however, financial advisors have to run their business day-to-day, which means dealing with investors concerned with volatility and maximum drawdowns.
There is also implicit risk in the stock market currently that financial advisors need to navigate. Whether it is alternative assets like REITs or managed futures to option, many products may benefit investors. Lucas points out that, “As asset prices are mean reverting, having a portfolio that is over allocated to assets that have benefited from investor exuberance – and that is less allocated to ‘out of favor’ investments- can be significant risk to the investor.”
Perhaps diversification is the best road to take, but it is important to remember that investments that are truly diversified by risk factor rather than asset characteristics are the way to go.