Itâs my firm belief that the riskiest thing in the investing world is widespread belief that thereâs no risk. Usually that dangerous condition stems from excessive conviction that the future is knowable and known . . . and benign. Today thereâs very little of that. I think thatâs a substantial positive.
It was one of the outstanding characteristics of the pre-crisis period of 2005-07 that most people were sure they completely understood (a) what made the economy work, (b) what the world would look like in five or ten years, and (c) how things could be fixed if problems arose. Today very few people feel that way. Thereâs nothing pleasant about the transition from feeling you know something to realizing you donât.
But the risk in an activity doesnât stem just from the activity itself, but from how people approach it. When equipment is developed that makes mountain climbing safer, people change their behavior in ways that make it more risky. Equally, much of the risk in investing stems not from securities, companies or exchanges, but from investor behavior. In short, risk is low when investors behave prudently and high when they donât.
A world thatâs perceived as safe can be rendered unsafe if the perception of safety causes investors to move out the risk curve, bid up prices, or take actions that assume greater certainty than turns out to be the case. I think that perfectly describes the years leading up to the crisis. Conversely, an uncertain world can be safer than people perceive if their concern causes them to behave cautiously (and especially if it causes them to sell down assets to prices from which the likelihood of further declines is reduced). Certainly few people in the world today are oblivious to the litany of outstanding negatives.
Please note, however, that while investor ardor and risk-blindness are at reassuringly low levels today â and that may be the best single thing that can be said for the current environment â the actions of central banks to minimize interest rates have served to force investors out on the risk curve in search of return. They may not be blind to the risks, but many are participating in pro-risk activities nevertheless. I refer to these coerced participants with a phrase from my late father-in-law, Sam Freeman: âhandcuff volunteers.â
The Role of Macro
These days we hear little about anything other than macro considerations. Security movements are highly correlated, meaning investment returns are more a function of broad market movements than individual security characteristics. And market movements are, in turn, primarily in response to macro developments.
Thus investors believe more than ever that the route to investment success lies in correct judgments about the macro future. This has given rise to so-called ârisk-on, risk-offâ investing, consisting of investorsâ attempts to profit by increasing their risk exposure when they expect favorable macro developments, and decreasing it when they foresee unfavorable developments. Since macro events determine most of the results, itâs on the macro that investors believe they should spend their time.
I couldnât agree less. Playing the market in the short term based on macro forecasts is one of the many things in investing that could add greatly to results if it could be done right . . . but it canât, certainly not consistently.
The expected value from any activity is the product of the gains available from doing it right multiplied by the probability of doing it right, minus the potential cost of failing in the attempt multiplied by the probability of failing. Investors are often blinded by the potential gains from a tactic and thus donât think much about the likelihood they can get it right. Because I think so little of the ability to make correct forecasts â and especially of the ability to get the timing right â I dismiss attempts to benefit from short-term macro judgments.
The best response when seas are choppy is to focus on completing the long-term voyage and not think about whether the next wave is going to push the nose of the boat up or down. Our investment destination is best reached by accurately valuing assets, assessing the relationship between price and that value, and acting resolutely and unemotionally when mispricings are detected. Thatâs still the best â I think the only â reliable path to investment success. Nothing about the current environment alters that one bit.
Some Thoughts on Strategy
While I donât believe in short-term tactical adjustments based on macro expectations, I do think clients, portfolio managers and strategists should take macro conditions into account when positioning portfolios for the medium term. And while Iâm a big skeptic regarding forecasting, I think we canât ignore the long-term secular outlook. (Is that an inconsistency? Absolutely!)
On January 10 of this year, I sent out a âclients-onlyâ memo called âWhat Can We Do For You?â It has since been posted to the website, and I hope youâll take a look at it. I said in that memo that I had come up with three questions that might help in setting strategy.
Do you expect prosperity or not? A simple, not-necessarily-precise judgment on this subject can strongly influence our choice of investment media and approach. As described at length above, itâs my conclusion that we wonât soon see a return to the prosperity of the pre-crisis years.
Of the two main risks in investing, which should you worry about more today: the risk of losing money or the risk of missing opportunities? Certainly todayâs macro uncertainties argue for worrying about loss. But even as the low-return climate suggests we neednât give much thought to opportunity costs, the near-zero returns offered on the safest investments (and the moderate level of asset prices) argue for assuming some risk in the pursuit of a more satisfactory return.
What kind of investing attributes should you employ today, aggressive or cautious? As above, I feel the pros and cons are balanced, and thus so should be our behavior.
On one hand, we face a lackluster general economic outlook and the threat of further negative developments that could be impactful but hopefully are not overwhelmingly likely. On the other, these worries may be offset to a degree by the lowness of asset prices and investor psychology. The former elements argue strongly against aggressive investing, but the latter â and the low promised returns on highly safe investments â argue that oneâs investment program should include some forward movement.
When I attended the University of Chicago it was very fashionable to use the qualifier ceteris paribus: âall other things being equal.â So I can flatly state that, ceteris paribus, an outlook characterized by slow growth, potential serious problems and great uncertainty should call for (a) more fixed income investments than equities, (b) more pursuit of value today than growth tomorrow and (c) more safe investments and less use of leverage.
However â and itâs the biggest possible âhoweverâ â all else is far from equal today. Safe investments have been bid up, such that the returns available on them are paltry at best. If you buy the ten-year U.S. Treasury note today at 1.7%, itâs hard to imagine environments other than depression and deflation in which youâll be happy with the outcome. So one of the more important conclusions is that this isnât a black-and-white world in which itâs reasonable to insist on safety and eschew risk. Unless you consider loss avoidance overwhelmingly important and can truly forgo making money, the approach for today has to balance risk aversion and the pursuit of return.
