Current market environment performance of dynamic, risk-managed investment solutions.
By Jerry Wagner
Investors are so different. They pursue different goals. They react differently to changes in the financial marketplace. Some are aggressive. Some are conservative. Sometimes they are very concerned with risk, and other times they seem able to ignore it.
This suggests that some investors don’t really understand what risk is all about.
After almost 50 years of researching the financial markets, operating one of the early hedge funds, and then running a multibillion-dollar turnkey asset management program (TAMP) for more than 40 years, I’ve formulated some thoughts on risk that I’d like to share.
First, you have to understand why risk exists. The simple answer? Because we can’t know the future or go back for a do-over.
If we knew the future, there would be no risk. Our foreknowledge would prevent us from encountering any bad events.
Similarly, if once we encountered misfortune we could retrace our steps and avoid the adversity, we could live life risk-free.
As some before me have noted, if we could live life looking in the rearview mirror, instead of through life’s windshield, we could always achieve happiness.
But life does not accommodate us. Try as we might, we find that we cannot study, work, or research our way to a place without risk. Having friends in high places or trying to avoid people in low places won’t guarantee an existence without peril. Nor will simply ignoring the threat of danger allow us to sidestep it. As I have written before, risk is always with us.
I could stop here and warn you that all investments have risks, and if you think you can have the returns of the stock market with no downside, please leave. Take your assets and put them into money-market certificates. Then pray that neither inflation nor a plunging dollar makes your funds worthless.
Hopefully, however, I have more to say (not that I disagree with the foregoing).
Recognizing market risk
Most people seem to believe that they can recognize risk. And there are risks that you can see a mile away. You know the risk of crossing a street or stopping on a railroad crossing.
The advice of one of the owners of a market-timing firm we acquired still rings in my ears. At every seminar on timing he would ask, “If you’re standing on the railroad tracks and a train is approaching, what should you do?” Of course, the answer is “get off the tracks!”
Yet, most truly scary risk, in and out of the financial markets, is not dealt with so simply.
Our variable sense of investment risk
Why is risk important to us sometimes and not at other times?
Some attribute this to a status quo bias. The evolutionary wiring of the human brain causes us to unconsciously assume the continuation of the status quo.
For example, say we just spent two years in a short-term depression, during which stock market indexes fell 50% to 70%. Status quo bias would cause investors to feel the stock market is too risky to buy into, and they would continue to feel that way for years afterward, regardless of the return potential.
On the other hand, after a lengthy bull market, it would be harder to find people who say that stocks are too risky to invest in. In such times, the focus is not on risk but on return.
Another bias working against a realistic view of risk is the familiarity bias. We encounter this bias every day. We buy popular brands. Why? Because they are familiar, they are talked about, and they are trusted. So when the stock market commentators say it’s a bull or a bear market, it becomes acceptable and we act accordingly, giving little thought to the less popular alternative.
Silent risk
Nassim Taleb, author of “The Black Swan,” has written of “silent risk.”
Risk is often silent. By its nature, the existence of risk is not realized until it is too late. Taleb compares it to sending troops out to the battlefield after the battle is lost.
And just as we are late to recognize risk, it is impossible to measure the extent of the risk until after it has occurred. Like those caught in the path of a hurricane, we are simply left to pick up the pieces and deal with the resulting damage.
Financial risk is not predictable, but ...
The bad news is that risk is not predictable with 100% probability. The good news, though, is the exposure to risk is predictable with certainty. As a result, we can prepare for it.
We know from studying history that stock market crashes follow the business cycle and occur rather routinely. When they will occur, however, is not knowable in advance. It may be just a couple of years after it last occurred, or it could be more than a decade afterward.
Using this knowledge of the certainty of a bear market does not eliminate risk, nor does it enable you to circle on a calendar when it will surface. But realizing that risk is always with us and preparing for it can mitigate the damages when risk inevitably surfaces.