Meditations on risk and investing

My MacroBusiness colleague The Prince has written at length on this site about some of the shortcomings of the “modern portfolio theory” (MPT) that still forms the basis of  investing today. I have had this post stewing for a while, so at the risk of repeating some of the material already covered in The Prince’s excellent series on superannuation, I will proceed. Hopefully this will reinforce some of the ideas already covered on this site.

To quickly review, MPT makes some very questionable assumptions about market structure and investor behavior. To name just a few of the most fantastical ones:

  • All investors behave rationally
  • There is always sufficient liquidity and any investor can lend or borrow an unlimited amount at the risk-free rate
  • There are no transaction costs
  • Investment returns are normally distributed

Have you fallen out of your chair laughing yet?

To be fair to the investment community, there are very few people in the industry that actually believe in these assumptions, particularly after the crash of 2008. Nevertheless, many of the key elements of MPT still have a great influence on the way money is managed today. Perhaps most problematic is the assumption made under MPT that risk is equal to volatility.

What is Risk?

But before proceeding any further in this discussion, we should ask a simple question. What is “risk” when it comes to investing?

As The Prince stated in a recent post, risk is the unknown probability of an investor losing money.

However, this is not at all how risk is defined in the “modern portfolio theory” that still forms the basis for portfolio management today. Instead, the risk of a particular asset class is defined as the historical volatility (measured by the standard deviation) of its returns. There are a lot of problems with this definition of risk. Firstly, as investors we do not care about volatility on the upside–what keeps us awake at night is the risk of volatility on the downside. The theory, however, makes no such distinction. And that’s not the only problem. As any good value investor will tell you, often the greatest investment opportunities are to be had when volatility is high and other investors are panicking. Are equities less risky now than they were in late 2008, when the market was crashing? They’re certainly less volatile, but I would argue they are more risky.

Measuring risk based on historical volatility raises all kinds of other questions, too. For example, what is the relevant time period to examine? This is an important question, because savvy marketers of investment products will often pick and choose whatever period looks most favorable.

Let me give an example that should be closer to home for many of our readers. Many observers, from the IMF to Australian banks such as ANZ, have argued that the huge rises in Australian property prices over the past decade can largely be justified by what they describe as a “permanent” downshift in Australia’s nominal interest rates.

And what evidence do these analysts provide that this decline in interest rates is permanent? None whatsover, apart from the observation that rates have been historically low for a decade now. From this undeniable historical fact, they jump to the conclusion that the enormous rise in Australian household debt is not a problem, because interest rates are and always will be low. Nothing to worry about. But what if we look back further than just the last decade? The chart below shows the the past decade has been a huge historical outlier.

Now, this is not to say that I think we will see interest rates of 20%, or even 10% again in Australia any time soon. If anything, I would expect lower rates. But the point is, we don’t really know. Millions of Australian households are essentially making a high stakes bet that the IMF and it’s friends are right, and the low-interest rate regime of the last decade really is “permanent”. Given the enormous average debt load, if they’re wrong, we are looking at a real debacle.
Risk vs Uncertainty
There are all kinds of events that impact markets that are inherently unpredictable. Take “black swan” events such as natural disasters or terrorist attacks, for example. The fact that such events have not happened in the past, or have only happened extremely rarely, is no guarantee that they will not happen in the future.
In the book, Risk, Uncertainty and Profit, Frank Knight makes the following distinction:
risk is present when future events occur with measurable probability
uncertainty is present when the likelihood of future events is indefinite or incalculable

In other words, the standard theory assumes that all risks are measurable, and it attempts to calculate the probability of those risks based on historical precedent. But in the words of Donald Rumsfeld, perhaps what we should be more concerned about are the “unknown unknowns.”

There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.

The unknown unknowns are events that are by their very nature unpredictable. To take an extreme example, if the earth is wiped out by an asteroid tomorrow, it doesn’t really matter whether you own stocks or bonds. Now, in case you wonder where I am going with these philosophical meanderings, these concepts of risk and uncertainty are actually of great relevance to the way we invest.

Does Time Diversify Risk?

Standard investment theory says that time is a diversifier of risk. The longer your investment horizon is, the less risky, because any bad years will be ironed out by the long-term upwards trend.  This is the classic “buy and hold” argument for equities. And the argument is not completely stupid. But it fails to take account of the distinction above between risk and uncertainty. In the words of the hedge fund guru Alexander Ineichen:

We believe time amplifies risk. It is true that the annual average rate of return has a smaller standard deviation for a longer time horizon. However, it is also true that the uncertainty compounds over a greater number of years. Unfortunately, this latter effect dominates in the sense that the total return becomes more uncertain the longer the investment horizon. The logic here is that over the longer term, more bad things can happen and the probability of failure (i.e., non-survival) is higher. The probability, for example, of San Francisco being wiped out by a large earthquake over the next 100 years is much larger than over the next 100 days. If accidents happen in the short term, one might not live long enough to experience the long term.

And now we return to the troublesome example of Japan.

Value investors have been pointing out for years that the Japanese stock market is cheap. Many stocks have been trading below book value for years. However, stocks (as well as everything else for that matter) only go up if the buyers are more powerful than the sellers. If there are no buyers, share prices do not rise, irrespective of their valuation or the “sentiment” among investors.

This lack of buying could be due to long-term changes in demography… Some ideas based on long-held beliefs simply might not work anymore if the regime—brought upon us through regulation or demographics or anything else—changes in a material way. As Keynes asked rhetorically: “When circumstances change, I change my view. What do you do?”Active risk management requires an open (and pragmatic) mind to “change”. So the whole idea of the equity risk premium and the idea that shares always go up in the long term could be regime specific, i.e. a function of population growth. Declining and aging populations (the “known”), potentially, could have an appetite for bonds, rather than stocks. Japan just could be a decade or two ahead of the curve in that regard; with the continuation and/or end of this trend being the “unknown”.

A recent paper titled Demographic Changes, Financial Markets and the Economy, lends weight to this argument. Based on a historical analysis of 22 country’s stockmarkets, you can see below that shares tend to do well when a large proportion of a country’s population is concentrated between the ages of 35-59. However, when people enter their 60s and retire, they tend to start selling off their assets, starting off with the riskiest ones, such as stocks and property. The Unconventional Economist has written about this concept with respect to housing prices. Exactly the same applies to equities. As populations age across the developed world, the demographic effect will start imparting a negative drag on the prices of risk assets like shares and house prices.

Such demographic factors are just one reason why (again, as pointed out by my fellow blogger The Prince), the so called “balanced” default option in most retirement funds (including Autralian super funds and US 401k plans) is actually extraordinarily risky — because it is making a very large bet that the equity premium in developed economies will be sustained over time.

So, am I suggesting that all investment theory is nonsense and that buy and hold investing is dead? No. But a smarter approach to asset allocation is needed. More in future posts. Suffice to say for now that it’s time to start questioning some of our assumptions about investment. They may not be serving us well.

Note: The views expressed in this post do not constitute investment advice. Please refer to the disclaimer in the menu bar above.

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  1. I am an investment professional. For me and my clients, buy and invest is dead.

    Markets are quite efficient WITHIN itself, which is to say securities are priced relatively accurately relative to one another.

    However, markets are priced very inefficiently versus bonds and cash. How did this arise? Over time, the herd has developed methodologies and trends which emphasise growth over defensive assets (and in future probably vice versa).

    These are much larger cycles but these pricing inefficiencies are exploitable. Therefore, “time in” is a lie. It is and has always been all about timing, though this may change in future depending on changing investment trends.

    One thing is abundantly clear. Humans fail to account for negative events sufficiently. It seems we are an optimistic bunch, assuming that tomorrow is basically a variation of yesterday.

    This means it is possible to bet against the farm every now and then and expect to win big every 7 to 10 years. This is known as Taleb’s Black Swan. But honestly, White Swans (that is predictable events) have similar effects because markets are so inefficient at processing paradigm shifts.

    On the issue of interest rates, I believe these are likely to rise. Why? We have enjoyed low interest rates because the developing world joined the global workforce and SAVED. These savings were amplified by credit, resulting in excessive money creation.

    Well, this process is now at an end. Credit creation is effectively stymied and Developing world is going to invest far less into Western Bonds. Therefore, rising interest rates will be the probable outcome.

    • lloydie some great points however i will add one point to your “time in” point. if the company has durable competive advantage (origin, woolworths, coca cola, wrigleys) time in definately matters. people are losing sight of the fact that smart value investment is about assessing the business not the buy/sell slip. momentum traders (which is current trend)were incapable of picking up BHP in november/december 2008, they missed (BYD 1211:HKSE) at 8 bucks when buffett and they missed it and 11-20 bucks for a long time too. the list goes on. buy and hold is not dead and style (investment style in this context) is not a trend. it is all about timing (and price) but time in still matters for the really wonderful businesses.

      • The idea of defensive plays is not statistically defensible IMHO. Sure great businesses survive but the macro factors will always overwhelm micro business strategies.

        For example, Sony, Toyota et al were all overwhelmed by the Japanese financial crisis in terms of stock valuations. One would have been better off in bonds from 1990 onwards.

        Just my two cents.

        • yep fair call. and with fed tampering with money supply macro factors definately matter more nowadays (somethine i disagree with buffett on–he says he ignores macro factors) but i would argue that sony is technology and was actually damaged by not only macro factors but poor management over a long period (micro) and that toyota is also tech (and autos are terrible businesses anyway–even toyota). only porsche is a good car business from my understanding (autos are like aviation–avoid them at all costs!). so therefore neither sony nor toyota had/have durable competitive advantage. as buffett says, i dont know where microsoft will be in ten years, but i do know that people chewing gum doesnt change. i am not sure i even believe in defensive investing, i just like good businesses, even though i guess you would say WOW and ORG, CSL etc are defensive plays.

  2. Thank you RA – great post and I love how you’ve tied it all together (I need to work on how to do this better, I’m usually better at public speaking than writing my thoughts down) lets keep this going!

    I’ll have my alternative solution to traditional asset allocation up soon (but its neither original or new – other thinkers and tinkerers have been doing this for sometime).

    Rumsfeld’s quote is an all time favourite – lots of parallels there (we share the same birthday, both use standing desks, but not the same politics or morals).

    • Did you have your desk custom made or are they available retail (serious question — I have back problems from sitting and have wondered if I should try standing)?

      • Actually you should switch btw both standing and sitting. Staying in any one position for 8 hours a day does alot of damage to the human body, that no amount of exercise the average person does will mitigate. You sit in a chair for 8 to 10 hours, 5 days a week and probably exercise 3-4 days a week for one hour at a time…..see the problem??

        You will actually find someone who exercises less but is more active during their day (perhaps a brickie) will burn far more calories.

        When you sit a section of your lower back is basically “asleep” and that’s why people get sore backs. Over time the shape of your body also changes, shoulders creep inwards etc etc. You’re body adjusts negatively to the position you keep it in.

        My recommendations for office workers:

        – use the stairs all the time (up and down)
        – stand up, stretch you’re entire body for 2 to 3 minutes every half hour to an hour.
        – Pick somewhere that is a 10-15 minute walk for lunch. There is a 20-30 min walk right there.
        – drink plenty of water
        – after work exercise hard. Pick something that will really get you going. Don’t just go through the motions at the gym.

  3. If you assume that the stock market is linked to the economic output potential of a country, then indexing people’s retirement to it makes sense on a macro level, as the retiree will not consume more than what the economy can produce.

    After the initial public offering, the shares are operating in the secondary market, therefore in theory the share price should not have an effect on the company’s fortune. This is however only true if a firm does not borrow money. Otherwise the ability to raise additional funds via share issue or borrowing will be directly linked to share prices, which in turns is an indicator of economic potential.

    • >After the IPO, the shares are operating in the secondary market, therefore in theory the share price should not have an effect on the company’s fortune. This is however only true if a firm does not borrow money.

      Except over 90% of management remuneration is tied to increasing share prices (by increasing earnings per share in anyway possible) through stock options.

      Many companies have changed their tactics in the short term in response to deleterious changes in share prices, without a commensurate desire to maintain a long term strategy of building shareholder wealth – particularly when they use leverage (or become lazy with capital).

      I would like to do away with secondary stock markets in their current form, as they certainly do not reflect the economic potential of a nation – only its ability to speculate and game a system for management gain.

      I prefer (but not completely agree with) Steve Keen’s idea of going back to pre-exchange/bourse style company stocks, which behaved similarly to bonds (most of the time, no method is perfect).

    • The biggest issue with the economic potential of a country is that it is corroded by national debt, both private and public. For a period we enjoy extra economic “growth”, but once debt limits are reached we pay a penalty for this artificial excessive growth. Therefore, hitching one’s retirement to the index would be a disaster. It’s all about timing for me, whilst watching national debt loads.

  4. In this post a few of the points are made by Satyajit Das in the thoroughly enjoyable ‘Traders, Guns & Money’.

    One other statement he makes is that in MPT, Quant analysis etc – the models measure error, however, bankers believe the findings can be inverted and measure certainty – which is proven, time and again, to be wrong.

    • Agree 100%. emh and mpt are bunk. Since when does volatility ever measure risk? It’s nonsensical. There is zero certainty when risk metrics can be thrown out the window at any time. I.e. The market itself is prone to collapse.

  5. RA,

    Good article. Does the buy and hold depends on what market your in, the time in the cycle, and what sector? I think it does, but I might be wrong.

    I lived through the dotcom in the USA, and many of the stocks never recovered, and some that those that did are at lower valuations even ten odd years later.

    One other point what about political policy changes that come out of left field? This can mess up your investments, and I can think of a few in the last few years.

    • Hi Adrian. Yes, I think the buy and hold argument depends on many of these things, and we need to be paying a lot more attention to what kind of “regime” we are in, rather than just blindly throwing money into an asset class in the hope that in the long run, prices always go up.

      Good point about political policy changes. These are really the “unknown unknowns”. The Prince has written about regulatory risk with super for example. In the housing market, the risk that negative gearing will be abolished, etc.

  6. RA, thanks for continuing with this line (also thanks to Prince). You’ve given two opposite definitions of risk in the same column – the Prince’s (ie “unknown probability of losing money”), and Ineichen’s (“risk is present when future events occur with measurable probability”
    ). For the sake of future posts, can we consolidate these to a consistent terminology?

    • Jackson – Actually in the paper referenced above, Ineichen says that his preferred definition of risk is simply “exposure to change”.

      In his words: “This definition is very simple and somewhat unscientific but pragmatic and very powerful as it doesn’t exclude uncertainty. Risk measurement deals with the objective part… The risk measurer either calculates bygone risk factors, simulates scenarios or stress tests portfolios based on knowledge available today according to an objective (and statistically robust) set of rules. Real risk (as in uncertainty), however, has to do with what we do not know today. More precisely, risk is exposure to unexpected change that could result in a large loss or non-survival.”

      The Prince’s definition is pretty close to this, and is my preferred one because it captures the uncertainty bit. I’ll try to be more clear about this in future posts!

      • Ineichen’s definition is quite reasonable. Knight’s definition is not on the money, a risk is an event that involves uncertainty and does not need to have a measurable probability (ie the probability of a risk occurring may be greater than zero, but completely unknowable).

        Risk events can also be positive or negative, of course. Its necessary to look at both, just looking at vol as risk completely misses the mark.

        Regarding the sharemarket, i agree with Prince’s view that secondary sharemarkets as they exist now are not beneficial systems. There is too much focus on share price by management, even if they dont intend to raise capital, and remuneration is too linked to sharemarket performance. This focus drives a lot of the poor outcomes that occur through drives towards “efficiency” and “capital light” business models. Certainly a lot of modern finance focuses too much on the sharemarket and not enough on other stakeholders and the long-term view of a business.

  7. Does Time Diversify Risk?

    I know of two fantastic charts that convey the issue with this statement better than any explanation I have seen yet. You guys have my email so drop me a line and I will send them to you! (I think they would make a great addition to this little piece.)

  8. as an investment professional ..whose made and lost the stockmarket I do appreciate this exchange .especially Lloydie.
    “It’s all about timing for me” he says ….and I do so agree.
    I detect the economist in some of these posts ..but the theory(ies) from these economists ..howsoever expressed ..and convincing as it may sound at first bite has never greatly impressed me. I always take some value from it …but for all of my stockmarket investing..I am always looking at the question : ” is the timing good?”. Will there be a buyer or three tomorrow at a higher price? ..and sometimes ( when short)..will there be a seller or three at a lower price tomorrow?

  9. Alex Heyworth

    “When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.” John Maynard Keynes,The General Theory of Employment, Interest and Money

    ‘The word “risk” derives from the early Italian risicare, which means “to dare”. In this sense, risk is a choice rather than a fate.’ Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk