September 18, 2019
Mark Minchin

Let’s talk about market risk

Whilst investors are right to consider global events and their implications, there is much more to the picture that should be considered if we are to be truly objective about managing risk.

Whilst investing has risks, not investing also has risks. However as human beings we have been programmed to focus more heavily on the possible downside (investing has risks) than the upside (not investing also has risks).

In psychology this human trait is known as ‘risk aversion’. Studies suggest that we ascribe as much as twice the value on avoiding losses as we ascribe to the opportunity for gains (see Kahneman & Tversky, 1979).

Being mindful of our own human biases is important when it comes to investing. Indeed, many of the evolutionary traits we have inherited make us prone to making poor investment decisions. This vulnerability is most acute in times of anxiety, as this is when we are most likely to make irrational decisions.

Do markets factor in economic threats?

Understanding how market prices are formed is also vitally important.

When we are concerned about a potentially impactful global issue – say the potential for escalation in US/China tensions in the South China Sea – then chances are that other investors are similarly concerned. If the issue or event has been well canvased in the public domain (as the South China Sea one has), then there is a good chance markets have weighed and measured that issue and their collective analysis is reflected in prices.

Markets are far cleverer than most people give them credit for. Studies suggest that current prices are the best available approximation of intrinsic value. This is because current prices are very good at quickly incorporating all available information and expectations.

Aided by modern technologies, market news travels faster and further today than ever before. This in turn enhances the speed and accuracy of the pricing mechanism as more and more people interpret the news and reflect it in prices.

Because ‘markets work’, major gyrations in markets are very rarely catalysed by issues or events that are already in the spotlight.

Major market dislocations are more likely to be caused by unforeseen events. To name a few: the US subprime mortgage crisis (2008), Hurricanes Katrina and Rita (2005), the Enron collapse (2002), the 9/11 terrorist attacks (2001), the dotcom crash (2000). Each of these events were either not well understood prior and/or highly surprising when they occurred. Markets therefore needed to adjust rapidly to factor in the information. When the price adjustment required is significant, we see market dislocation, as prices gap lower.

Given the events that cause the most turmoil are the ones that are inherently unpredictable, then it may be logical to conclude that we shouldn’t let worrisome, yet well canvassed current events sway our investment decisions. Our decisions may be better informed by considering information that is known, than ruminating about the unknown.

How reliable are markets in delivering long term returns?

In this regard, thinking about markets through the construct of ‘capitalism’ can be helpful. Investors who invest in the whole market (as opposed to a small handful of stocks) need not be concerned about specific issues and risks faced by one company or another. What these more diversified investors are more concerned about is how successful the whole market – or capitalism – will be in the future.

Put simply; capitalism is a system that allows money to be invested freely by private owners. These owners (people) freely allocate their funds where they believe they will get the best return. Through this mechanism capital is allocated efficiently to the most deserving industries and businesses. People driven by their own profit incentive learn quickly, allocating and reallocating their capital as times and technologies change.

How successful capitalism is at allocating a nation’s scarce resources is reflected in the stock market’s long-term return. Over a hundred years in America, this long-term return has been around 9% pa. And whilst the available data series is shorter in Australia, the return we’ve achieved is about the same.

Whilst capitalism has encountered more crises than I care to list here, it has been infinitely more successful in its goal of efficiently allocating capital than any other system.

Looking back through history, what is clear is that free markets (or capitalism) learn from every crisis, rebuild, reallocate and ultimately go on to higher highs.

Historically, betting against capitalism has been a very bad choice. Yet, scary news sells well – mainly because it plays to our human fears and anxieties.

For as long as I’ve worked in markets there has been a steady flow of doom and gloom forecasts. In 2008 for example, “the End of Capitalism” was a front-page story. This sort of stuff can be a good read, but tends to be wildly inaccurate.

How accurate are market forecasts?

If you ever want to consider the likely accuracy of ‘expert forecasts’ regarding financial markets, a simple Google search can throw some light on the matter. While writing this paper, I do a Google search on “Financial Markets Forecasts”. The first article that captures my attention is a Financial Times piece dated 11 July 2013.

In reading I see that a central theme of the article is that both equities and bonds were looking expensive (back then in 2013), bonds dramatically so. The article goes on to quote Cliff Asness, a well-known academic and leading market guru whom I hold in high regard.

Cliff is quoted as saying that markets are so overvalued that his prospective return from a 60% equities and 40% bonds portfolio over the next ten years would be no more than 2.4% pa.

At the time of writing, this article would have had a great sense of gravity about it. A serious paper, quoting a market great, and proffering a dire warning. However, reading this article now, knowing what transpired, gives it an entirely different air.

The actual returns for the subsequent five years are shown in the table below:

International EquitiesInternational BondsBalanced

Of course, Cliff’s predictions could still turn out to be accurate as the decade still isn’t out, but acting on the article in 2013 wouldn’t have been a great move so far….

What is the objective of the financial press?

Here in lies another great misconception. Most investors believe that the media are there to help them – to inform and educate. In truth though, the main goal of the media is to ‘sell eyeballs to advertisers’. Stories that are shocking and sensational sell, so good journalists hunt for good controversies and bold predictions (rather than trying to find the most prudent, educative things to write).

How often do markets crash?

Now I will try and stop talking about psychology and capitalism and turn to the facts about markets. When looked at objectively, these facts will give you far better guidance than any expert opinion piece or forecast.

If we consider the US stock market (which has the longest series of available data) over the period 1926 to 2018 (92 years), we find the average annualised return has been 9.8% p.a. with the dispersion of returns summarised as follows:

(returns were between)
No. of years
-40% to -50%1 (1931)
-30% to -40%2 (1937 & 2008)
-20% to -30%3 (1930, 1974 & 2002)
-10% to -20%8
0% to -10%10
0% to +10%16
+10% to +20%17
+20% to +30%20
+30% to +40%12
+40% to +50%3
+50% to +60%1

So, in over 92 years there have only been 5 years where the annual market return was in the “worse than -20%” category. This is interesting, but most investors diversify their portfolios beyond straight equities in order to better manage their risks. So, for most prudent investors, their portfolio is likely to be much less volatile than the S&P 500 quoted above.

How often does a ‘Balanced Portfolio’ tank?

Over a similar period (1928 to 2018), a classic, ‘balanced portfolio’ made up of 60% equities and 40% bonds (here we consider 60% S&P 500 and 40% US Treasuries) has delivered an average annualised return of around 7.6%, or around 80% of the return of straight equities.

The balanced portfolio saw 19 years with negative total returns during the period from 1928 to 2017 (so 21%), but the vast majority of these negative years saw only shallow drawdowns (less than -5%).

The worst drawdowns for the balanced portfolio since WWII were in 1974 and 2008. Each of these drawdowns were less than 15%. The returns on just the S&P 500 in those years were more than twice the losses of the balanced portfolio.

How risky is it to ‘sit out’ of markets in cash for a while?

So, if the worst possible drawdown is in the order of -15% and the long-term average return around 7.6%, is it worth engaging in very low probability speculation about when the next major drawdown will be? Or as investors, are we better served by accepting that bad years will occur occasionally, but the long-term return will be sound? Most would agree that the rational decision would be the latter.

If despite this logical reasoning we remain fearful, then what are we to do?

The classic response is to remain firmly invested in cash. Or sometimes an extremely cautious investor will augment their cash portfolio with gold (which is understood to rise in value in the event of a calamity).

The first limb of this strategy is to sit patiently in cash (& perhaps gold) and the second is to begin investing in shares, bonds and property at low prices when the predicted calamity occurs.

If we look at this strategy objectively, we find many problems with it.

To start with, the long-term return on the underlying investments is very low (almost nothing). Currently the real returns on cash in Australia are near zero. That’s because the cash rate (1%) is below the inflation rate (1.7%), meaning that the inflation adjusted return on cash is negative.

Meanwhile, the long term expected return on gold is similarly close to zero. This is because over the very long-term gold merely holds its value. It produces no dividend, interest or rent and has minimal industrial value, so unlike shares, bonds and property – its long-term return potential is structurally limited.

Thus, this strategy can only be successful if the owner’s prediction of market calamity comes to fruition relatively quickly AND they have enough conviction to invest in shares, bonds and property in the midst of the predicted crisis when prices are low.

The probability of any investor doing BOTH these things (predicting the crisis and then having the conviction to invest amid the crisis – when almost nobody wants to invest) is incredibly remote.

To make matters worse, there is a considerable opportunity cost of not being invested. The longer the predicted calamity takes to occur, the more costly the “safe” strategy becomes.
If we assume a long-term rate of return of 7.5% on a balanced portfolio, and a worst case return on a balanced portfolio of -15%, then the strategy is destined to fail if the predicted calamity takes more than two years to transpire. Mathematically this is a poor gamble.

How can I build the safest possible portfolio?

So how can we build a portfolio that hedges our bets and keeps us safe from the next equity market downturn? Here are some tips:

  1. Diversify broadly. Every asset class faces risks, even cash (fiat currency) is exposed to the perils of inflation and debasing. 
  2. Own some shares. The World will always need primary industries and the quality businesses that operate within them. Hospitals, infrastructure, grocery stores, freight companies, tech – we can’t really do without them, so they will all continue to operate and earn profits. So own lots of quality businesses across a range of industries. 
  3. Own some property. We can’t build more land, and there are more and more people in the World. So, land is always likely to have tradable value and has the additional benefit of commanding a rental income stream. 
  4. Own some bonds. Bonds are less volatile than shares and property and they provide a highly predictable income stream. Additionally, bonds issued by credible governments and corporates tend to rise in value in times of crisis, when shares and property are falling in value. This inverse correlation can be hugely helpful in limiting your portfolio’s downside in times of crisis.
  5. Hold some cash (but not too much). Cash doesn’t earn much, and comes with its own risks (fiat currency), but nonetheless cash is still helpful in the portfolio context. Cash provides liquidity and flexibility. It is a pot of reserves that can fund expenses for a period and may also facilitate the topping up of cheap assets in times of dislocation. 

This may sound a bit like a “Balanced Portfolio” – and it is. But if you’re especially cautious, your diversified portfolio doesn’t need to be a 60/40 (growth/defensive), you could for instance opt for a 40/60. The latter will show much less volatility, yet still provide most of the long-term return of the former. Sacrificing a little return for peace of mind may be a sensible price to pay for some. Investing purely in cash and gold is way too risky for all.

Zero risk – is it achievable or desirable? (LIVEXchange 2019)

Mark Minchin was recently asked to join an expert panel to talk about managing risk at the LiveX (Australian livestock exporters) conference in Townsville. Risk Tolerance Behavioural Finance Sustainability

November 12, 2019