I talk about market risk quite a bit and try to emphasize market risk is not static. This idea is not supported by mainstream thinking or financial marketing.
“Financial Advisors” ask you how much risk you are willing to accept – high, medium, low, none. My answer is as little as possible. But they will tell you in order to obtain higher returns you have to accept higher levels of risk. This is a load of bull or should I say a load of bear. If you hear these questions, ask the advisor what exactly is risk. How do they monitor risk?
What is risk? They may tell you something like how much you are willing to lose when the markets go south. Huh. But how can I achieve higher returns if I lose a lot of money. Exactly, how? Well, you will earn a higher return until at some point you lose most of your gains. But no worries, if you just buy and hold you will again earn a high annual return until you lose it all over again.
So if you cannot sleep well because you might lose a lot of money you should set a lower risk level by allocating a lower percentage of your money in equities. Say only 50% to equities, that way you earn a high return on 50% of your holding until you lose all those gains and start over. Huh? I call this diversifying your losses. It also diversifies your gains on the way up.
What advisors are really doing is trying to reduce their workload and your market stress, not your market risk. Reducing market risk requires a lot of work and since most advisors get paid in fees based on the funds you have at risk, why would they work hard to reduce their fees by reducing *your* market risk. Right you say that is why I follow an investment group or research funds myself.
The question you need to ask about your investment group or research is whether you are doing this to reduce stress or actual risk. What’s the difference? Most retail investors work to reduce market stress by diversifying, choosing the funds with the highest recent returns, or following the herd.
Humans have herding instincts. Think back to junior high when you had to dress a certain way, have your hair a certain way, and stressed about peer pressure. We feel better, safer when we belong to a group or run with a herd that cheers us on. Investment clubs can be like this. We reduce our market stress by following the group. The herd leaders will warn us, right?
For most, what the group is doing matters more than trying to understand something complex like market risk. You are not alone; the markets in general have herding characteristics.
James Grant, editor of Grant’s Interest Rate Observer, recently equated the stock market to a herd. If all stocks, sectors and asset classes are generally moving in the same direction you are probably safe. But like herds, when danger is near the herd begins to scatter and risk aversion happens as the threat gets close. Many in the herd do not see the threat, they are merely responding to the herd.
When the herd in front of them scatters, market stress goes up and they become uncertain as to which way the threat is coming from. Why is one leader running one way and the other another way? Why are some turning and some charging ahead? What’s the threat, where is the threat? Is the threat selling (turning) and locking in losses or charging ahead into the claws of the bear? Why is the investment club’s stress up?
Ask yourself, why do funds with the highest return in the bull market have the lowest returns during bear markets? How come there are so many geniuses during bull markets and so few during bear markets? I’ll give you a hint; the market spends 80% of its time in bull markets. If you are clueless would you rather be right 80% or 20% of the time. Never mind the market loses over 80% of those bull market gains on average during the other 20% of the time during secular bear markets.
Market internals track the herd. The breakdown of market internals is like the herd changing directions and scattering – a threat is approaching. Risk aversion happens as the threat gets close. Both warn of increased market risk even if you can’t see what the threat is. Unlike animal herds and our society where everything happens fast, deteriorating market internals happen at the speed of a sloth and are easily missed by a running herd. Anyway the markets keep going up for a while after market internals begin to scatter, so they are dismissed.
Ask yourself, have you been reducing market stress by running with a herd or chasing past returns or are you monitoring real market risks. Did you shift to a 50% allocation to equities to reduce stress or risk? A 50% allocation does carry lower market risk, but at some point that allocation should be 0%. Do you know when? And will you know when to go back to a high allocation? Most retail investors have the lowest equity allocations at market bottoms when market risk becomes low again but market stress is at extremes.
There is no perfect market risk meter that flips at precisely the right time, but there are some that should be heeded even if it means giving up some gains at the top or bottom. Market risk is simply not static and a set diversification like Life Cycle Funds simply diversifies both losses and gains. And do you think all those millionaires (billionaires) living in the Hamptons are buy and hold investors?
So what is your desired level of market risk? Mine is as low as possible with the highest long term returns possible, thank you. How about you?
At TSP & Vanguard Smart Investor we avoid market risk in two ways: We avoid exposure to equities during the time of the year most corrections and losses have historically occurred and also when cyclical indications of elevated market risk are indicated by market internals and elevated risk aversion. We recommend increasing exposure to equities when higher risk-adjusted returns are indicated.