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RISK & RETURN
How to Expect the Unexpected
One of the market’s wise men – someone who is known and respected by everyone but shuns the limelight – believes the financial markets represent pure chaos. He contends that indexes, and exchange-traded funds and other financial products exist to provide a sense of order to the markets so the human brain does not shut down due to information overload.
Some might find his view to be extreme, but his financial chaos theory raises interesting questions.
How much control does anyone have over the market? The answer is not much. Over time, of course, stock prices rise, and thus the natural position of most investors is long. Aside from trying to let time work for you, and not against you, investors can control investment fees, and they can try manage risk through effective diversification, while resisting the urge to “greed in” at market tops and to “panic out” at market bottoms. Other than that, most everyone is left hoping that the market cycle will be in their favor when they need to convert their securities into cash.
And it is precisely because of the difficulty of timing the market that some investors feel compelled to monitor and manage risk. They do this by buying what is essentially an insurance policy for their portfolios, usually in the form of put options, which increase in value as stock prices decline. The strategy is reasonable, except it has not worked well in recent years. The stock market has steadily advanced, and any corrections have been short lived. In other words, anyone who hedged their portfolios spent money on something that they simply did not need.
Rather than engaging in the fear-mongering that is often used to persuade investors to buy hedges – a technique arguably borrowed from the life insurance industry - it’s more useful to offer a framework for discussing what is obliquely referred to as “tail risk” by institutional investors.
But first let’s define what is meant by tails.
In markets, as in life, we hope that most experiences fall somewhere in the middle of the bell curve. But sometimes life and markets do not behave as we would hope. When bad things happen, that’s called a left-tail event, which is almost universally referred to simply as a “tail event.” When good things happen, investors – at least those who love jargon – talk about “right tails” to represent upside. In fact, the chief investment officer of a major bank recently told us that many clients have right-tail risks, which is to say they are underinvested in stocks.
While it is easy to get lost in high-minded discussions of risk and investing, the natural question is how often do these tail events happen? They happen enough to be a legitimate concern, and something many investors monitor on a daily basis.
The second key question, however, is what happens after sharp corrections. Does the stock market snap back, and race higher, which has been true for the past decade? The third key question is personal. Do you have the risk tolerance, and fortitude, to see your investment accounts plunge in value, especially if you need access to that money because you are retired, or have other immediate obligations?
Those questions rarely get the attention that they deserve. People are busy. They are generally optimistic in their outlooks. Many do not even know to think of their investments in risk-adjusted ways, which is yet another glaring example of the difference between how money is handled on Wall Street and Main Street.
But there are some signs that this is changing. There is some debate that retirees, many of whom are living longer and have not saved enough money, should own more stocks, and less bonds, and hedge the portfolio to protect against sharp declines.
These advisors advocating hedging investment portfolios like houses or cars. Most people’s investment portfolios are worth more than their homes, or cars so they contend that it makes sense to insure them. After all, everyone buys home and auto insurance and never complains if they never need to use them. On the other hand, investment hedging can be expensive, and though the cost can often be reduced, or eliminated, investors give up potential future gains.
Perhaps the Solomon-esque solution to these issues is to simply determine if your portfolio is exposed to tail risk. After learning that, you can better decide what makes the most sense. After all, as the great philosopher Francis Bacon wrote so long ago, knowledge is power.
Is Your Portfolio Truly Diversified? Probably Not.
At this very moment, some advisor, somewhere in the securities industry, is confronting a difficult reality with their clients.
They know that bonds are often as risky as stocks, and that stocks and bonds often behave like each other. Yet, there is often little they can do for clients outside of the traditional balanced portfolio that is often dictated by a client’s age. Those constraints reflect an unforgiving amalgamation of suitability rules that are enforced by rigid compliance departments even though they often make less sense than the ideas from the 1950s that still dictate how money should be invested to reduce risk.
We were reminded of these difficulties during a recent conversation with a top advisor. He was frustrated at not being able to properly care for a client who had just sold a piece of jewelry for a few million dollars. The client wanted to invest in the equity market, but the advisor thought stock prices were too high. He did not feel comfortable investing in bonds, which he said – and we agree – are rather risky as the Federal Reserve is in the midst of raising rates. The advisor wanted to sell downside puts on blue-chip stocks that pay dividends, which is a way to buy stocks below market prices, but he knew compliance would block that even though his client was wealthy. Why? The client was in his 70s. So, rather than fighting the compliance department, he put the money in a cash account where he could wait for an opportunity rather than slotting the money into some allocation that a compliance clerk would approve.
“The Street was built on 60/40,” he said, referring to the widespread idea that portfolios that are divided between 60% in stocks, and 40% in bonds have superior risk-adjusted returns
Perhaps that was true in the past, but it is less true at the present moment as the Federal Reserve is trying to extricate itself from the easy-money policies that helped save the global markets from destruction.
According to one chart making the rounds, the traditional 60/40 portfolio returned about 14% during the 1990s with a 9% volatility. Now, the strategy is not about half as effective and volatility is slightly higher, and the portfolio basically behaves like a stock portfolio.
In other words, the supposedly balanced portfolio is no longer so balanced.
Moreover, international stocks, which have helped to diversify and hedge U.S. portfolios, are also less effective. As globalization, and electronic trading has linked markets and economies, many once diversified assets are trading like each other. The phenomenon is often evident on a daily basis. Bad news in one market rolls around the world, knocking down stock prices likes a chain of dominoes. Some investors, like our advisor friend, are waiting for the proverbial shoe to drop.
“What happens when stock go down, and bonds go down? We know rates will rise and bonds will go down,” he said. “How do we handle that? How do we deal with compliance?”
The answer, at least at corporate levels, is increasing legal reserves in anticipation of lawsuits that will be filed when the bear market hits. At the advisor level, one answer is finding technological tools to determine the effectiveness of a portfolio’s diversification. This is done by measuring correlation, which is a key concern of institutional investors even though many advisors and individual investors rarely hear about it.
Correlation measures relationships between different investments; it ranges from -1 to +1 (securities move in lock step, which often happens during risk-on episodes). Positively-correlated investments rise or fall in unison. Negative correlation means the move in opposite directions. When there is some kind of risk event – say a trade war that drives stock prices lower all over the world – institutional investors say the world has gone to one. In short hand, that means correlations are high, and there is no safety to be found in markets.
Now, correlations are elevated, a fact that will surprise many people because this type of narrative – even though it is critical to one’s investment health – is almost always absent from mainstream discussions of markets. We believe investors and advisors should regularly review the effectiveness of their portfolio’s diversification. This is especially true as some advisors, and many institutional investors, are now wondering if balanced portfolios that are so commonly recommended really balance risk and reward. We consider correlation levels as a key part of our risk-management framework, and one of the must have conversations between advisors and clients. After all, as we like to say, the hedge preserves the edge. But what if there is no hedge in the hedge? Then, many investors might own so-called “Texas hedges” that increase risk rather than reducing risk.
Bottom line: Know what you own and manage risk to maximize returns.
Volatility is one of the most widely used, yet misunderstood, words in the investment world. It means so many things to so many people that volatility is at risk of becoming another Wall Street word that does not mean much of anything at all. Should that happen, many people will find themselves exposed to unnecessary difficulties at a time when so many are already concerned that the margins of safety of their investing lives are under threat from many different forces.
According to a recent Annual Aegon Retirement Readiness Survey, 16,000 workers and retirees across 15 countries said financial market volatility was one of their top three worries, following concerns that governments would reduce retirement benefits, and people would outlive their money. The concern about volatility seemingly comes from nowhere.
Since the Global Financial Crisis of 2008, world markets have essentially rallied higher, and volatility has ebbed ever lower as central banks used easy-money policies to save the global economy. These policies basically vacuumed risk out of the stock market. In 2017, the Standard & Poor’s 500 Index experienced the least volatility since 1965. The current investment year has certainly had some erratic moments – Feb. 5, for example - but the primary proxy of volatility, the CBOE Volatility Index, or VIX, remains around 12, far below the long-term average of 19.
While it seems paradoxical that people all over the world are worried about volatility when it barely exists in financial markets, the survey’s findings are likely a leading indicator. We all know the world’s major governments are struggling with massive debts thanks to the financial crisis. At the same time, many of the world’s largest economies have aging populations and people are relying on their portfolios like never before. Most people have not saved enough for retirement.
Those issues will likely exacerbate the already increasing difficulties many investors have remaining calm under pressure when markets suddenly, and sharply, decline. Some hedge funds are betting on this; they are tracking America’s aging patterns to get ahead of massive withdrawals from retirement accounts that could push stocks lower, or cause structural problems among the many low-fee investment funds that are so popular.
So what do you need to know about volatility?
Blackrock, the world’s largest investment manager, PIMCO, and Goldman Sachs, have told clients that volatility is an asset class like stocks and bonds. Yet, many people – and this includes huge swaths of people on Wall Street and Main Street – still think volatility refers to fluctuating security prices. After all, everyone likely remembers J.P. Morgan’s famous quip when he was asked what he thought of the stock market. He said it would fluctuate. A lot has changed since the great financier died in 1913.
While volatility definitely describes the ups and downs of investing, volatility is also a real, concrete part of markets that is traded and analyzed.
There is a volatility curve for the Standard & Poor’s 500 Index, and other indexes, and stocks. This is just like the yield curve for the bond market. A growing number of sophisticated investors – and this includes Warren Buffett - trade, track and analyze volatility because it influences all financial assets and the world’s markets. Even variable annuity prices are influenced by the volatility of the Standard & Poor’s 500 Index.
To us, volatility is part of a four-part framework for discussing investing with clients, and safeguarding portfolios. Many people, for example, think they own a diversified portfolio that protects them from the market’s inevitable ups and downs. In reality, most portfolios decline when the CBOE Volatility Index, or VIX, rises. This is why we analyze volatility and develop bespoke portfolio scores to help advisors track an otherwise invisible risk factor.
While entire books have been written about volatility - Natenberg’s Volatility is a favorite of ours – a few key facts will help most everyone better navigate the market.
First, imagine an ocean. Think of your portfolio as a boat on the water. When markets rise or fall, it generates waves. The waves are volatility and the waves essentially impact everything, even the shape of the sea.
There are two types of volatility – and this fact eludes many - realized (sometimes called historic) and implied.
Just as the moon controls tides, volatility is heavily influenced by realized volatility, which refers to what has happened in the past. Understanding historical volatility offers insights into trading patterns, and market personality. Low volatility securities, such as utilities, often do not move very much. High volatility securities, such as biotechnology stocks, are the opposite. Indexes, which are comprised of many different types of stocks, are usually somewhere in between. As stock prices rise, for example, realized volatility usually declines. If a stock sharply declines, say because of a bad earnings report, realized volatility can increase. Either way, realized volatility functions like a giant magnet on the financial market, and on implied volatility, which gauges what may happen in the future.
Implied volatility is concerned with the future, and it is the primary focus of many investors. If you can understand how volatility will behave in the future – and this is based on an understanding of historical volatility and various events that cause implied volatility to undulate - you have a keen insight into the behavior of stocks. Hence, many investors compare realized and implied volatility to contextualize the financial world.
Now, let’s consider VIX, which is the primary proxy for equity volatility. The fear gauge is designed to provide investors an idea of what might happen to the S&P 500 Index over the next 30 days. So, if VIX is around 12, it means the stock market is expected to move .75% each day for the next 30 days. Investors then decide if they think that level is appropriate, or not.
Historically, VIX’s long-term average is about 19, which implies that VIX’s current level – about 12 – will inevitably increase. Why? Because volatility is a mean reverting asset that behaves like a rubber band. Stretch it out, and it snaps back.
Bottom line: we live in an era of volatility that is increasingly influencing the nature of markets, and the pathway of portfolios. If you don’t know your volatility score, you’re missing a critical piece of the investment puzzle.
The Language of Money
Winston Churchill once quipped that America and England are two countries separated by a common language. We have often thought of this as our travels, and lives, keep us alternating between Wall Street and Main Street. On Wall Street, most everyone intuitively understands the need to define and manage risk to maximize returns. On Main Street, beating the benchmark is the ultimate definition of success.
But consider this: a portfolio manager we know, someone who has managed money at the world’s largest, and most respected, asset management firms and pension funds, said he would have a lot of explaining to do if he made a 30% annual return when his benchmark rose 15%. Why? The immediate bias would be that he took on far too much risk to make his money.
On Main Street, however, the manager’s results would be manna from heaven. The fund would likely get awarded with some superlative return score, the financial press corps would celebrate the manager’s market-beating genius, and money would pour in from everyone eager to invest with someone who has the Midas touch. Of course, we all know how this story tends to end.
Yet, this simple construct is essentially how Main Street approaches Wall Street. They come to the markets looking to make money, which is appropriate, but they are little prepared for what they find. They think they are long-term investors, but in reality, the only thing about them that is long-term is the amount of time they spend in markets. They often do not own stocks, or bonds, long enough to even benefit from the market’s natural cycles. This is an accepted fact at the highest levels of Wall Street, and it is part of the lubrication of liquidity that helps markets function. Advisors, who are the front line of the financial services industry, are left to deal with the consequences.
We propose a common language, a lingua franca, based on what really moves markets. We propose a focus on risk before return, and process before profit. We could focus on more than 2,000 investment factors that influence markets and portfolio, but we think understanding four key words are maximally effective: volatility, diversification, tail risk, and concentrated-stock risk. Anyone who understands the meaning of those words will understand markets - and their investment portfolios - in ways that are truly meaningful. Moreover, those words will help your clients understand what you do for them, and what they are doing, in a different light.
While those words are immediately familiar to you, and perhaps to some of your clients, everyone brings their own definitions. And so it is important to define terms, which is exactly what happens everyday, all day, when institutional investors meet to discuss market opportunities and realities.
This definitional exercise insures everyone is speaking about the same thing and is focused on the same thematic. Those common definitions can reduces misunderstanding. Also, this framework shows clients that there is much more to successful investing that just paying the lowest fee. It shows them that it is possible to define, measure and control risks. Once that happens, investors have a better chance of making time work for them, not against them. That will help break the perpetual boom bust cycle and even out the odds for your clients and you by hopefully preventing them from “greeding in” and “panicking out” of their investments. In other words, there are no guarantees on Wall Street except for risk. How much risk are you willing to take to realize your objectives? The answer is critical. Our proposal for a four-point common language can help you have conversation that matters.
A Conversation on Risk & Return
We want to start an ongoing conversation with you about risk and return. We want to move beyond headlines, and the incessant focus on buying this fund, or selling that stock or bond. We want to get away from the perpetual speculation about what might happen if oil prices rise or fall, inflation increases, job growth is too strong, or if the Federal Reserve raises rates faster, or more aggressively, than excepted. In short, we want to focus on themes that permeate everything that we do. We plan to use the summer lull – and we hope this seasonal factor holds true this year – to focus on issues that are relevant at all stages of the market cycle, and in an investor’s life. Over the next few months, you will receive a weekly essay from us on issues that are critical to the wellbeing of your practice, and those of your clients. Afterward, we will, from time to time, send you essays on topics that are central to your practice, the market, and the financial wellbeing of you and your clients. But first we want to establish a framework, and a context. The framework is critical. It’s likely that many of your clients cannot fully articulate their key concerns due to the lack a common framework for discussing investing. We will incrementally reveal our suggested framework in each week’s edition of our company’s note, Risk and Return.
Think about that for a moment. We live in an era in which we have identified thousands of factors to measure and analyze investments, and yet many people still struggle to meaningfully address something that is increasingly important to their total well-being: investment portfolios.
Perhaps this is because we live in the age of buzzwords that reduce complexities into slogans that fit on bumper stickers. Consider defined outcome investing. If you do X, then Y, you can retire, send kids to college, and live happily ever after. Advisors exist within this construct as the financial equivalent of self-driving cars. Robo-advisors is another catchy phrase, suggesting that all anyone needs to do is use technology to take advantage of another buzzy phenomenon to invest in inexpensive financial products.
To be sure, there is some truth in all of those ideas, but they miss some key points that are critically important, especially when wealth increases, people age, or they live far longer than they anticipated. Low investment fees, for example, are important, but in reality they often obscure the fact that investors are piling into cheap beta that follows the market up and down. All of this stuff encourages group thinking about investing and what defines success.
At StratiFi, we believe technology can help people make better investment decisions. In our view, and not everyone will agree, technology is best used in conjunction with the human touch. Consider the last time you visited your doctor. Technology enabled your physician to listen to your heart, check your pulse, and analyze your blood. But the real value was generated by your physician. People want smart technology, but they need smart advisors.
To us, advisors have the great heroic role because advisors are on the front lines of the war. They fight these battles daily. We believe technology can help advisors more effectively solve problems and be a force multiplier that enables people to do more in less time. Words are powerful, and they can be made even more impactful with a visual image that shows investors how much risk they are taking to realize various returns. This is, in essence what animates our PRISM Rating software. Everyone knows their credit scores, and all sorts of other numbers that contextualize them in the world, but almost no one – at least anyone who is not an institutional investor - knows their risk score. We think that needs to change.
The nation faces a great financial literacy crisis, and an even greater retirement crisis, and we want to try to change outcomes. We want to help solve some of the most difficult, pressing questions of finance: how to define and manage risk to maximize returns in a way that is intuitive, and easy to use. We believe that part of the solution includes creating a community that is focused and engaged in conversation about these principles. If we succeed, we will witness the value of Metcalfe’s Law, which essentially states that the value of a network is proportional to the square of the number of users. The law is rooted in the telecommunication sector, but it has become a key principle of the value of social networks.
We want you to have intuitive tools that are easy to use and understand. We think this will help bring you closer to your clients by showing them how a combination of a common language, technology, and investment disciplines, all of which are embedded in software, can lead to better outcomes. We think that addressing those issues will add a degree of stability to your practice, help you grow your business, and help your clients have less volatile, more predictable relationships with their investment accounts. By defining risk, we can see returns as they truly are.
We want to help advisors become the single most valuable asset in their client’s portfolios. We think we can do this by helping advisors become risk managers and educators. Those two roles are woefully absent from the lives of most investors, and it is time to change.
Do you want to learn how technology can help you invest more effectively, while reducing client inertia, and generating business?