On March 12, 2012 the WSJ had an article titled "Why Stocks are Riskier Than You Think." http://online.wsj.com/article/SB10001424052970204795304577221052377253224.html
In the article, the authors make certain recommendations based on what I'd describe as common sentiments of market participants, as reflected by the way investing and economics are taught at our universities. As a proud graduate of the University of California Santa Barbara with a BA in Business/Economics, I can tell you quite frankly that very little of my college education has proved applicable in the real world of investing. The root of the problem is the "Efficient Market Hypothesis," which states that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. The long-term outperformance of the likes of Warren Buffett, Peter Lynch, Bruce Berkowitz, Charlie Munger, Glenn Greenberg, Seth Klarman, Michael Price, Martin Whitman, etc. can only be explained as aberrations. In the Superinvestors of Graham-And-Doddsville Warren Buffett tackles this theory in a practical and sensible manner, which I could only wish to replicate. http://www.tilsonfunds.com/superinvestors.html
The beauty of the "Efficient Market Hypothesis" is that if it were true, it would make finance/investing science-like, explained by understandable principles and formulas. While I would agree that markets are often "mostly efficient," I am 100% against EMH. Most universities and market participants define risk in investing as being the same as volatility. In the WSJ article this is a primary argument of why stocks are "always risky" because at any point in time they could be volatile. To truly understand risk however, it is essential to first place an adjective before the word, risk. There are different risks such as liquidity-risk, interest-rate risk, inflation-risk, market-risk, credit-risk, commodity-risk, etc. It seems that the authors are referring mostly to market-risk which relates to short-term changes in pricing, and it is a significant mistake by the authors to not specify this more clearly. Currently a fixed income portfolio consisting of Treasuries or high-quality credits would entail taking enormous interest-rate risk on any longer-term maturities. As of 9-10-2012 the 30-year Treasury bond yields 2.83% and the 10-year yields 1.68%. These yields are equivalent to an equity trading at a P/E ratio of 35 and 59.5 respectively. Even worse the upside is extremely limited in comparison with equities which often if bought at reasonable prices, offer dividends, and potential for significant appreciation as earnings grow.
Other recommended investments such as "guaranteed" fixed-annuities also take significant interest-rate risk, and would likely perform horribly in an inflationary environment, which does seem somewhat relevant when one observes the rapid printing of money occurring on a global basis. In addition products such as annuities often incur higher fees, and substantial liquidity risks. Many times I have had clients in which their previous advisor had recommended an annuity during a short-term market scare, and after realizing that the world wasn't going to end, the clients could only exit the low-yielding product after paying substantial "surrender fees." While having a 10 or 20 year investment plan is always advisable, reality often changes the equation such as the loss of a job, or increased medical expenses that alter one's plans drastically. Annuities certainly do make sense for some people in the right circumstances, but I'd almost always prefer an actively managed portfolio using a value investing strategy specifically suited to meet my needs and objectives. There are reasons that insurance companies take the risks of "guaranteeing" payments, and their potential profits come at a cost to the investor in the annuities in excess of the transaction fees.
Another recommendation which I disagree with is the recommendation for the average investor to regularly buy puts on one's stock portfolio. While this might somewhat "hedge" the portfolio from short-term price fluctuations, there is also a significant cost in doing so. In a study the CME concluded that about 76.5% of options expired worthless meaning the odds are stacked against the buyer. In addition let's say that you buy puts on the S&P 500 to hedge your stock portfolio or mutual funds. If the market drops 10-15% does the investor take profits on the stock options, or hold them until maturity? At that point in time investors often extrapolate that short-term price declines will continue well into the future and might hold on to the options, and if the market were to recover above the strike price, the hedge which once was so valuable, would expire completely worthless. The practicality of the strategy is dubious at best for the common investor, but it does provide an attractive sales pitch for brokers who can in their sales slogans "potentially reduce risk by buying options." Maybe they can or maybe they can't, but there is significant execution-risk in implementing such a strategy. In the zero cost strategy the authors' outline that has upside of 6% versus 15% downside risk, with the investor also eating the fees associated with the transaction, I really must question the authors' sense of actually making money in the markets. Why would you limit your upside so drastically while almost eating a full bear market (-20%) on the downside? Even worse, what if the put gets exercised causing you to take a 15% loss and then recovers significantly; assuming you reset the trade your upside is now limited to 6%, after already eating into 15% of your principle? These strategies are paper strategies, and just as portfolio insurance sounded like a good idea before the 1987 stock market crash, they are flawed in application.
The authors also recommend "managed products" which work to reduce risk through diversification and/or hedging. One type of managed product is "managed futures" which I've had the unfortunate experience of witnessing in action in a negative light. These programs can use just about any sort of investment instrument such as corn, S&P futures, crude oil, etc. Often it involves timing, technical, or momentum indicators, which attempt to take advantage of short-term market movements. While I am confident that there are some solid programs, there is a lot less regulation in the Futures Industry (Peregrine, MF Global, Refco, etc). Many of these programs have exceptionally high fees (I've seen as high as 10% a month in a couple disgusting examples) and misleading marketing. Often a sales point is made that managed futures outperformed in 2008 when stocks, bonds, and commodities plunged. While an index of managed futures might have outperformed, I'd bet a lot of money that if you took a large sample of mutual funds with different strategies such as bearish and bullish, that you'd also find outperformance in comparison to those same investments in a down market. This would occur through having completely opposite strategies hedging one another out, and then comparing the average to an all long portfolio such as the S&P 500.
The benchmark index most sited when touting managed futures is the Barclay CTA Index. I'm not aware of a way to trade this index like an investor can indeed trade the S&P 500; I know the turnover has been higher on that CTA index, the survivorship bias inflating historical returns. Therefore if a fund previously outperforming has a terrible year and then loses 80-90% in a year, which some do due to the increased leverage, it can be removed from the index to skew performance. This is misleading and unlike hedge funds which can only be sold to accredited investors, managed futures are available to retirement and normal accounts for individuals of all ages. Needless to say this has the potential to be quite problematic and maybe I'm naïve, but I can only associate the fact that this is indeed the case, to effective lobbyist efforts, and perhaps a lack of knowledge of the industry. Therefore I argue that most of these "options" presented for the common investor might seem good on paper, but might not offer to be a better alternative than stocks.
If I was a novice investor reading this article, my first decision might be to close all my accounts and hoard my money under a mattress. The problem with this strategy is that there is in my estimation, at worst a 50/50 possibility of substantial inflation within the next 10 years. Even lower rates of inflation compounded over time have significant impacts on one's purchasing power meaning that if your money is doing nothing, you are still losing.
The above table reflects $100,000 of investable assets over a decade with 3% annual inflation, earning no interest shows just how damaging inflation can be to an all-cash portfolio. Losing 26.26% in purchasing power over 10 years certainly doesn't seem risk-free either. For those advocating long-term, low-yield bonds, or fixed-annuities, I'd suggest looking at what happened to bond prices when Paul Volcker beat inflation into the ground through increasing interest-rates. Prices plummeted causing substantial losses on securities such as Treasuries, which some market participants would define as being the closest thing to risk-free.
While one may or may not agree with my objections with the article, it is a less fruitful task if I do not offer another alternative. Unfortunately there are no easy answers to this complicated issue, but a good place to start is by defining the risks that you seek to avoid. At my firm, T&T Capital Management (OTCQB:TTCM) we attempt to keep the risk of taking a permanent loss of capital to an absolute minimum. To accomplish this task we perform extensive research and analysis on each and every security that we ultimately buy for our clients. We only invest in opportunities where we feel that the odds are stacked in our favor. This might mean buying a company at a discount to "liquidation value" or for better companies, a discount to "intrinsic value." Usually we shoot for a 40-50% discount which allows us an adequate margin of safety as defined by Benjamin Graham, and further eloquently enhanced by Seth Klarman in his book "Margin of Safety." It also allows for more substantial upside in our estimation that buying a mutual fund or index assuming our analysis is sound (which we hope). This doesn't mean we can only invest in stocks as we will look at any security that we are capable of analyzing. High-yield fixed income may be "risky" in the eyes of EMH as it can be volatile similarly to equities, but if we can buy a bond with a 10-30% yield, that also provides a substantial cushion from liquidation value in an event such as bankruptcy or another type of reorganization, than this strategy might be "safer" than buying treasuries or a fixed- annuity with the inflation-risk inherent in those options. Once again our risk that we are concerned with is defined as the risk of taking a permanent loss of capital.
While we do use stock options, we only sell them for the purposes of generating income, reducing risk, and instilling a disciplined profit-taking strategy. For instance let's say there is a company that is trading at 50% of what we would believe to be a liquidation value in the worst of scenarios, how would I not be reducing risk by selling a naked put on that company? Often naked put selling is a frowned upon strategy as the risk is unlimited up to the stock reaching zero, but if we can get returns on the maximum risk greater than our investment objectives, a naked put selling strategy will ultimately be less risky than just owning stocks outright. For instance if we sold a put on a stock trading at $10, at a $10 strike price expiring in January for $1.50, my target profit would be $150 on a maximum risk of $850. Therefore the potential target profit equates to 17.6% on the maximum risk. The worst case scenario is that if the stock expires below $10, I will end up owning the stock at $8.50 a share, which represents a 15% discount to the price at which I could have owned the stock at on the day I set the trade. Therefore if the stock went to $0 I'd lose $850 versus $1,000 if I owned the stock outright. 15% of protection nearly cushions the investor from what would be described as a bear market in the stock as defined by a 20% drop in price. In reality many of my most successful long-term investments have actually occurred when I've been exercised on the options, and end up owning the stock at an even more attractive price allowing for ample upside. In addition the selling of options in this disciplined and value based method, which I am describing, makes you The House in a sense. If nearly three quarters of all options expire worthless over time, than this strategy should generate solid income while the biggest risk is owning stocks that you want to own at cheaper prices.
These strategies are defined as value investing and have been implemented successfully by both professionals and individuals. While the options strategies are less commonly practiced, and we believe to be somewhat unique to our firm in how they are applied, value investing is the one investment philosophy that truly makes sense to me personally, and to us as a firm. Obviously an investor must keep money needed for short-term expenses or reserves liquid, which is why on that portion of capital liquidity-risk and market-risk should be the primary priorities. For an investor looking to protect their capital and maximize risk-adjusted returns I believe that the strategy employed by TTCM offers the best opportunity to do so. As with any other strategy there will be short-term periods of underperformance, and performance itself is never guaranteed, but the process is sound and worthy of careful consideration. These strategies that we recommend are the ones that we use for our own money and for our families' money, and I'd suggest asking whether or not any advisor that you have can make that same claim, and if they can't I'd urge you to take a second look.