We Can't Redefine Risk, It's The Price Silly

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Includes: DIA, IWM, QQQ, SPY
by: Dale Roberts

Summary

Investors on average have performed poorly due to the emotional reaction to stock market price swings.

Too many investors typically do a lot of buying near the tops (when they feel comfortable) and then sell when prices are falling as they are gripped with fear.

It may be dangerous to try to redefine risk, or suggest that investors who address risk are just pessimists looking for the downside.

Quite the contrary, any intelligent investor is an optimist by trade. One has to be a long term optimist to invest in the stock markets.

It may come down to Mr. Buffett's suggestion that if you can't handle a 50% correction, don't invest in the stock markets.

A recent article from Seeking Alpha author Eli Inkrot suggested that "It's tough to make a case for pessimism". I have written several articles that suggest that at today's valuations there's likely "No Money To Be Made From Here". And that the one might stand a very slim chance of beating a lowly bond heavy balanced portfolio from here. And that article showed that this is the third longest bull market in market history, and that history might suggest the odds or potential for a correction are increasing. I've also asked readers if, in the next correction, will they "be a winner or a loser?"

But I would suggest those articles are more about managing expectations and hopefully helping investors prepare for the next stock market correction, and at this time - evaluate that risk tolerance level. They are not about pessimism, at all. Quite the contrary.

Here's the first definition for pessimism that comes up courtesy of Google.

a tendency to see the worst aspect of things or believe that the worst will happen; a lack of hope or confidence in the future.

"the dispute cast an air of deep pessimism over the future of the peace talks"

synonyms:

defeatism, negativity, doom and gloom, gloominess, miserablism

That definition of pessimism flies completely in the face of what makes an intelligent investor. An investor is and has to be an optimist by design, or he or she should not invest one penny in the stock markets. One has to believe that human ingenuity and hard work and innovation will continue to drive a robust economy that creates jobs and increases gross domestic product and creates growing earnings and profits for the stock markets of the developed world. One might also be even more optimistic over the longer term to suggest that the growing middle class in Latin America, Africa and the Far East and the Middle East might create one of the most advantageous investment periods in history. That demographic and economic phenomenon might a wonderful reason for an intelligent investor to be very, very optimistic and hopeful for the future.

And this from psychologytoday.com:

All About Pessimism.

The glass is half-empty and storm-clouds loom overhead (never with a silver lining).

Any person who holds this point of view when it comes to the economies of the world and the companies that create and sell products, that there is no silver lining and things will always be bad for the companies and economics - well that person would not be investing. An intelligent investor is the ultimate long term optimist. But he or she is also aware of market history.

That investor is prepared for whatever the markets throw at them. When an investor is better prepared, they are likely to respond more rationally when the markets throw a temper tantrum, or get way too excited.

We should remember that it is investor psychology that leads to staggering losses and poor results for many investors.

From Merriam-Webster here's the definition for preparedness.

"The fact of being ready for something: the state of being prepared."

The state of being read, well that seems downright prudent when it comes to investing, especially as it relates to market corrections.

Personal emotion must be taken out of the game. But that intelligent investor should also recognize and understand the emotional trends that drive a stock market. As Benjamin Graham suggested, the stock markets are a voting machine in the short term and a weighing machine in the long term.

Benjamin Graham wrote eloquently and at length about risk and the emotional reactions of investors. He wrote about being prepared for the irrational behavior of markets. He did not have a lot of faith in most investors being able to emotionally withstand the full roller coaster ride of the markets to the degree that he suggested defensive investors (that's most of us) should hold anywhere between 25% and 75% bonds, depending on what offered better prospects.

When authors suggest that we should dismiss risk - that everything still looks rosy from here - well I think that chorus could be very dangerous. There are numerous articles on Seeking Alpha that suggest it was easy to navigate through the market correction that was created courtesy of the Great Recession. Just pick a few dividend stalwarts that made it through the recession by increasing their dividends and suggest it is easy to stare at the dividends and not the portfolio falling by 40-50%, and you've got an argument that might dismiss the emotional reality of what actually happened in 2008-2009.

What's more, if an investor is going into a correction with the plan and strategy that they can and will ignore the price and simply watch the dividends and find comfort in the dividends, then that investor is setting themselves up for failure - in the case that they will actually look at the portfolio value. As we could hazard a guess, ALL investors will know and look at the market value and that will have an emotional effect and consequence. I am not saying all will react in a negative way, but they will certainly feel it.

And if that investor has the portfolio plan that they will manage price risk by simply watching the dividends, that investor is likely flagging that they have a very low risk tolerance level. Perhaps their risk tolerance level is lower than the average stock investor. If that's the case, the need to manage risk is more important for many dividend growth investors who plan to ignore price risk.

Quite simply we should bring this back to Warren Buffett and one of his most famous quotes. From Forbes favorite Buffett quotes...

"Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market."

Warren of course is suggesting that investors pay attention to price as he knows what drives investor fear. Now Warren is suggesting is that they should not have an all-stock portfolio. We know that investors can manage the price risk of stocks by adding bonds and cash. And given the valuations of the day, it's likely or possible that one would not give up anything by way of total return if they now switched to a balanced portfolio. In my opinion, and as I wrote in this article there's a strong likelihood that a balanced portfolio will outperform an all stock portfolio over the next several years.

Suggestions

Don't ignore risk, or try to redefine risk. It is price risk that has caused the tsunami of damage to portfolios over the last several decades. That is not likely to change. Instead an investor should address that price risk, head on, be prepared for that price risk. Furthermore, as I wrote in a recent article ...

Don't fear a correction, confidently whisper "bring it on." When the markets fall they are going on sale and you can typically purchase long-term value. Your dollars will buy more purchasing power from the bottoms. When the masses run away from the companies they own, they are typically willing to sell at fire sale prices. Get your wallet ready and line up to the right.

That's the position I take with clients. I ask them to realize and admit that a correction will come, and that it's a good thing, no strike that, it's a great thing - the holdings will go on sale. It's one of the greatest opportunities for investors. It can boost your returns; the buying in the correction might be the greatest event and activity in your investment career. But we have to realize the portfolio will fall in value. There's the potential that it will by 40-50% or more if you're in a stock heavy portfolio. It's important to frame that risk and face, head on, the historical drops in stock and balanced portfolios.

It's my opinion that risk cannot be redefined. And in fact, redefining risk likely increases the risk and potential losses for those investors (who embrace that strategy) as they are not emotionally prepared. There's a reason why, in the army, they prepare soldiers in training by recreating war with the smoke and the noise and the confusion. They don't suggest soldiers should not worry about the chaos of real war because they will be holding some wonderful weapons and they have incredible support and strategies. No, they show them that war is hell. They attempt to show them what war feels like.

They prepare.

Happy investing, be careful out there, always know your risk tolerance level, and why not give international diversification a thought or two?

Disclosure: The author is long SPY, VIG, BRK.B, EWC, EFA, AAPL, ENB, TRP.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Dale Roberts is an investment funds associate at Tangerine Investment Funds Limited. The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process. The views expressed are personal and do not necessarily represent those of Scotiabank.