risk
The Hidden Trade-off: “Risk-adjusted Returns”
You surely have noticed this by now: we disagree with conventional ways of doing many things. Modern Portfolio Theory (MPT) forms the theoretical underpinnings of a lot of investment practice today, without adequate understanding of its deep flaws.
MPT defines volatility as risk. We believe, as Warren Buffett does, that volatility is just volatility – the normal ups and downs – for long term investors. So one common practice is to promote the advantages of getting 80% of the market returns with only 50% of the risk (for example). This supposedly is a superior “risk-adjusted return.”
But you could use the same statistical methodology to show that it may cost you about one third of your potential wealth in 25 years to have a 50% smoother ride on the way. For an investor with $100,000 in long term funds, this might be a $250,000 future shortfall. The question might be, “What fraction of your future wealth would you sacrifice in order to have less volatility on the way?”
The idea of sacrificing future wealth is a lot different than the idea of reducing risk. But they are two sides of the same coin. This is the hidden trade-off in superior risk-adjusted returns.
Our experience is that people can learn to understand and live with volatility. We believe investors get paid to endure volatility.
Of course, our philosophy is not right for everyone. Volatility is easier to tolerate for investors with a longer time horizon. But we believe everyone should see both sides of the coin before making a decision to forego significant potential future wealth for a smoother ride, less volatility, along the way.
Clients, if you would like to talk about this or anything else, please email us or call.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
The Trouble with Zig and Zag Theory
The idea behind massive diversification, owing a bit of everything, is that some things zig when others zag, keeping the whole bucket steadier. Great theory.
The problem is that things do not zig and zag ALL the time. When the big downturn comes, they all go down together. Oh, some things do not go down – but those things also tend to never go up, either.
The mathematical basis for massive diversification is Modern Portfolio Theory. It depends on different types of assets behaving more or less independently of one another – zigging and zagging. The lack of correlation is what drives the hypothetical usefulness of the theory.
In the big downturns, however, the correlations may converge. In plain language, in times of market stress, even independent investments may act as though they are related. The theory may not work due to systematic risks.
This is a real problem, because it is a theory that sometimes has the potential to drive investors to diversify into sectors and asset classes which may hold unknown risks, in the interest of avoiding market volatility.
This only makes sense if one defines volatility as risk, something to always be minimized and avoided. We think it makes more sense to understand volatility as an integral and necessary part of long term investing, a feature to be tolerated (or embraced) as the price of pursuing market returns over the long haul.
Investing in fluctuating markets with confidence requires us to know where our needed cash will come from – only long term money should be invested for the long term.
Clients, if you would like to talk about this or anything else, please email us or call.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Volatility Versus Risk
In the investment world, we often speak of the riskiness of an investment in terms of volatility: if an asset’s price changes rapidly and unpredictably, it tends to be spoken of as risky, and if the price tends to stay the same, it is usually regarded as “safe.”
In the short term, this is reasonable. If you have $100 today and you know that you will need $100 a week from today, the only sensible move is to put your money someplace where you know its value won’t change. Investing it in a volatile market means you might make a few extra percent your original money, at the unaffordable risk of coming up short when you actually need your money.
When we start to look at investing for the long term, though, we can start to see the difference between volatility and risk. Suppose you take your money and bury it in a hole in the ground for 30 years: this is about the least volatile “investment” you can possibly make. You can reasonably expect that the value of your buried money will stay nearly constant. Yet, because of the existence of inflation, it is almost a certainty that your money will lose a lot of purchasing power over the course of 30 years. Essentially you have a 100% chance of losing value over the long haul despite having virtually no day to day volatility.
On the other hand, if you took your money and invested it for 30 years, you can afford a lot of up and down movement during those 30 years—as long as the final value is higher than what you started with. If your investment has a daily gain 51% of the time and a corresponding daily loss 49% of the time, you can be fairly confident in your eventual profit—even though you’re watching the value go down several thousand times over the course of those three decades.
None of us know the future: there is no such thing as a guaranteed investment, and every investment incurs some form of risk. But it’s important to understand the difference between an asset’s volatility and its risk. For long-term investors, looking past day to day volatility can help you find bargains that are not as risky as you might think.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the loss of principal.
Behavioral Economics and The Price of Stability
The first theory of economists was that human beings act rationally. When they realized they needed a new theory, the field of Behavioral Economics was born.
One of the key findings of Behavioral Economics is that the pain of a loss is twice as great as the pleasure of a corresponding gain. Rationally speaking, if you earn $5 it should feel just as satisfying as if you earned $10 and then lost $5 of that—but we still feel the sting of the loss harder, even though the outcome is the same.
If people weigh these two otherwise identical outcomes differently, when it comes time to invest they will wind up paying more for $5 earned in stable investments than they would for $5 earned in volatile investments. There is no shortage of expensive products designed to pander to this tendency by selling the promise of stability at a premium.
The necessary conclusion we see—the one nobody else seems to—is that if the price of stability is too high, the potential rewards for enduring volatility must be larger than they otherwise should be.
These concepts shape our work, our strategies, and our tactics. “The pain of a loss” is determined by one’s mindset, training, and understanding. Many great investors (and many of our clients) feel no pain over short-term losses. Some are even gleeful at the chance to buy securities at bargain prices. One of our roles is to help you develop more productive and effective attitudes about investing, and we believe that by training yourself out of irrational pain over short-term volatility you can perform better in the long run.
The opinions voiced in this material are for general information only and are not intended to provide specific investment advice or recommendations for any individual.
The illustration is hypothetical and is not representative of any specific investment. Your results may vary.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
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