Ride or Hide - How to think about risk

As the world works through the implications and seriousness of COVID19 there is no shortage of advice providers discussing the duration and severity of the medical crisis, the economic impact, how to manage your portfolio and what to tell clients.  Let’s discuss portfolio risk and leave medical advice to those better suited to the topic.  

Investors of suitable age that have been through multiple corrections are asking whether now is the time to move more money into equities or other risky investments in the hopes of enhanced returns.  All investors conceptually understand risk but the investing industry has  likely done us a disservice in its definition.  One of the most common tenets in investing is that the expected rate of return for a security goes up with the level of risk that security displays also known as the capital market line.  The capital market line slopes upwards to the right with greater risk and return as you move away from the origin. I recently read a note from legendary investor Howard Marks where he explains the CML with greater depth describing riskier investments as those for which the outcome is less certain.  His view is that you can buy less risky assets and achieve higher rates of return with greater consistency if you purchase assets at the right price.  Leveraging Peter Thiel’s thinking in the book Zero to One Peter’s experience is that when you go to the extreme right of the CML into venture capital one investment out of 10 determines the success of a 10 year fund.  This would adjust Howard’s illustration from less of a normal distribution to a fat tailed one at both ends as you move to the right along teh CML.  The key now is to buy quality assets at the right price instead of reaching for returns that have a lower probability of occurring for the majority of investors who try.   

The most common advice in a capital markets crisis is do nothing and the most common emotion is the need to do something.  Invest for the long term is a phrase that permeates at times such as these.  That is the right answer if you think things are going to look the same pre and post crisis, all assets were impacted in the same way, you are looking for the average return or don’t have to draw an income during the pull back.  Those are a lot of “what ifs”.  Som Seif of Purpose Investments summarized the preceding thoughts in a recent client message.  One opportunity he raised was the spread between the yield on government bonds and blue chip dividends which are currently as wide as they have ever been.  He congratulated all those that had benefited from holding government bonds leading up to the crisis but suggested it was time to take profit in government bonds and shift to quality equities with yields of 5-6% or more before the preferential treatment of dividends versus income.  Other thoughts are that equities will be the winners coming out of the crisis but generally and currently credit markets have dislocated further than equities despite being higher in the capital structure.  Times of crisis are when opportunities arise for asset managers to outperform from the actions they take to reevaluate their portfolio positions.  For those that simply promote staying the course don’t be surprised if their results reflect the average minus their fee.  

The final point on risk is that there are many definitions of risk.  I will mention the ones I see as the greatest risk for investors but there are others.  There is goal risk where you fall short of your income needs whether that means achieving a 4% or 8% return.  The one that requires 4% will view risk differently than the one that requires 8%. For asset managers there is underperformance risk (beating their benchmark).  Many managers reduce this risk by emulating the index vs. those that are comfortable being different knowing they will underperform at times but outperform over the long term.  There are a limited number of Warren Buffets, Howard Marks and other acclaimed investors in the later camp or smaller managers that are under the radar or inaccessible to most investors.  There is illiquidity risk for investors that have short term cash needs and career risk for asset managers who would rather protect their career than stretching for client performance at the expense of a bad outcome that could cost them their job. My advice is to look for those that have the confidence to be different with a track record to back up their past decisions, otherwise go passive.

Risk is a far more complicated term than it appears at first glance so beware of simplistic phrases that provide overly simplistic solutions.  Your best course is to speak with your advisor, asset manager and do your own reading to understand risk, history and how to best capitalize when opportunities such as the recent crisis present themselves.