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What Is Risk Really All About?

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by: Invest With An Edge

By Jerry Wagner

I was reading my email this morning, and I came across this query: “What were you doing at this time last year?” I wondered, so I checked my calendar. I realized I had been writing the following article that I think remains relevant, especially after the downturn last week (discussed further in today’s “Market update” at the end of the article).

I also thought it was appropriate to remember the anniversary of the Las Vegas massacre that was discussed in the article. It’s hard to believe that it has been a year since the tragedy and also to realize that no motive has been found after a year of investigation. Our thoughts and prayers continue to be with the affected families, all of whom I’m sure are still suffering its aftermath.

Remembering events of a year ago can give us a better perspective on the events of late. The decline experienced last week was sudden and volatile, but with the perspective that comes from viewing the gains experienced over the last 12 months, the downturn still amounts to only a 4% hiccup. It is just like the 10%-plus correction in January-February of this year that has been wiped out by the stock market returns since then. It reminds us too that “risk is always with us” and of the value of dynamic, risk-managed portfolios.

Here’s the article, originally published in late 2017.

***

Investors are so different. They pursue different goals. They react differently to changes in the financial marketplace. Some are aggressive. Some are conservative. Sometimes they are terribly concerned with risk, and other times they seem able to totally ignore it.

This suggests that most investors really don’t understand what risk is all about.

After almost 50 years of researching the financial markets, operating one of the early hedge funds, and then running a multibillion-dollar turnkey asset management program (TAMP) for the last 36 years, I’ve formulated some thoughts on risk that I’d like to share.

First, you have to understand why risk exists. The simple answer? Because we can’t know the future or go back for a do-over.

If we knew the future, there would be no risk. Our foreknowledge would prevent us from encountering any bad events.

Similarly, if once we encountered misfortune we could retrace our steps and avoid the adversity, we could live life risk-free.

As some before me have noted, if we could live life looking in the rearview mirror, instead of through life’s windshield, we could always achieve happiness.

But life does not accommodate us. Try as we might, we find that we cannot study, work, or research our way to a place without risk. Having friends in high places or trying to avoid people in low places won’t guarantee an existence without peril. Nor will simply ignoring the threat of danger allow us to sidestep it. As I have written before, risk is always with us.

Now, if this was the typical investment article, I could stop here and warn you that all investments have risks, and if you think you can have the returns of the stock market with no downside, please leave. Take your assets and put them into money-market certificates. Then pray that neither inflation nor a plunging dollar makes your funds worthless.

Hopefully, however, I have more to say (not that I disagree with the foregoing).

Recognizing market risk

Most people seem to believe that they can recognize risk. And there are risks that you can see a mile away. You know the risk of crossing a street or stopping on a railroad crossing.

The advice of one of the owners of a market-timing firm we acquired still rings in my ears. At every seminar on timing he would ask, “If you’re standing on the railroad tracks and a train is approaching, what should you do?” Of course, the answer is “get off the tracks!”

Yet, most truly scary risk, in and out of the financial markets, is not dealt with so simply. And, as if to provide the exception to even these elementary examples, it seems like every day we read of someone getting killed simply crossing a street or a railroad crossing!

Our variable sense of investment risk

Why is risk important to us sometimes and not at other times?

Some attribute this to a status quo bias. The evolutionary wiring of the human brain causes us to unconsciously assume the continuation of the status quo.

For example, say we just spent two years in a short-term depression, during which stock market indexes fell 50% to 70%. Status quo bias would cause investors to feel the stock market is too risky to buy into, and they would continue to feel that way for years afterward, regardless of the return potential.

On the other hand, after an eight-year bull market, it would be harder to find people who say that stocks are too risky to invest in. In such times, the focus is not on risk but on return. Sound familiar?

Another bias working against a realistic view of risk is the familiarity bias. We encounter this bias every day. We buy popular brands. Why? Because they are familiar, they are talked about, and they are trusted. So when the stock market commentators say it’s a bull or a bear market, it becomes acceptable and we act accordingly, giving little thought to the less popular alternative.

Silent risk

Nassim Taleb, author of “The Black Swan,” has written of “silent risk.”

Risk is often silent. By its nature, the existence of risk is not realized until it is too late. Taleb compares it to sending troops out to the battlefield after the battle is lost.

And just as we are late to recognize risk, it is impossible to measure the extent of the risk until after it has occurred. Like those caught in the path of a hurricane, we are simply left to pick up the pieces and deal with the resulting damage.

I thought of this hidden, unmeasurable aspect of risk on the first day of this month:

With the arrival of autumn, the night must have been a bit cooler. The crowd had enjoyed three days of country-western music. In a venue and town devoted to pleasure, the audience was listening to the last act. Undoubtedly, many were picking up and heading home to beat the rush. Others were savoring the last delicious moments of a glorious weekend.

The glow of neon bathed the northern horizon with colorful light, even though the sun had set in the west hours before. High above towered a magnificent structure, golden glass and steel, with a hundred windows—some lit, some dark. It was a place that many of the concertgoers called home, at least for a night or two. That any of them were at risk was probably the furthest thing from their minds.

And then the shots rang out.

Only then did they recognize the risk—one that was statistically minuscule just moments ago. Now it was a certainty.

Before the dissonant sound of gunfire drowned out the melodies from the stage, the effect of the risk was unmeasurable. Moments later, it was quantifiable, and the number of dead and wounded marched ever higher for days afterward.

As a nation, our hearts were broken, our minds were shaken, and our prayers for strength and support were, and are, offered to the victims and their families. They never knew that their fate was intertwined with an unknowable risk that could not be eluded without foreknowledge. There was no do-over for them.

So it is, on a far less tragic stage, for investors.

Financial risk is not predictable, but

The bad news is that risk is not predictable with 100% probability. The good news, though, is the exposure to risk is predictable with certainty. As a result, we can prepare for it.

We know from studying history that stock market crashes follow the business cycle and occur rather routinely. When they will occur, however, is not knowable in advance. It may be just a couple of years after it last occurred, or it could be more than a decade afterward.

It has been 10 years since the market topped out in 2007, preceding a 50%–70% downturn that took a year and a half to recover from. The rally that ensued afterward continues today, the second-longest in stock market history.

Using this knowledge of the certainty of a bear market does not eliminate risk, nor does it enable you to circle on a calendar when it will surface. But realizing that risk is always with us and preparing for it can mitigate the damages when risk inevitably surfaces.

***

Market update

Financial markets took investors on a wild ride last week. The VIX index (also called the “fear index”), which measures S&P equity market volatility, soared to levels not seen since the eight-day January/February correction—although, it is worth noting that the earlier levels were substantially higher.

While stocks had been registering overbought levels the previous week, last week the same readings quickly plummeted to oversold levels. And the levels hit were historic. Similar low readings have only been registered 18 times since 1928.

Following such low readings, the market has usually failed to recover in the next month (only 44% of the time). However, it has rallied over the next three-, six-, and 12-month periods more than 60% of the time.

What is also encouraging is that when a bounce back occurs the day after such a large collapse, the percent of the time that is profitable is greater for all three time periods, growing to about 82% of the subsequent 12-month periods.

Similarly, when the market rebounds on a Friday after such a decline (like it did last week), stocks have gone higher five days later 73% of the time. And when the S&P 500 gains more than 1% on a day that ends up more than 1%, but ends down for the week 4% or more (as it did last week), the index has closed higher a week later 83% of the time.

Still, even after reviewing these statistics, it does seem like something has changed in the stock market. Stocks with high price-earnings ratios were the worst performers, as were low-dividend payers. The condition for year-to-date numbers at the end of September was exactly the opposite. Growth stocks performed worse than value stocks, again just the opposite as before last week.

The beginning of earnings season was flat to disappointing, as only a few, mostly financial sector firms reported. The really substantial earnings reports come in over the next two weeks. By the end of that period, more than 60% of S&P 500 firms will have reported. At the same time, economic reports were also mixed, with four overachieving, four underachieving, and three coming in on target.

Besides the overbought condition, the only other obvious culprit causing last week’s weakness would appear to be the Federal Reserve’s actions to continually push interest rates higher, with three rate hikes already this year and a fourth sure to come in December. This had caused the 10-year government-bond yield to spike to over 3.25% just before the end of the previous week.

Normally, an eighth Fed hike (since December 2015) would coexist with higher inflation. Yet higher inflation has not yet surfaced. This has caused a wide array of market watchers (like me) to be concerned that the Fed may be moving too far, too fast. The result could badly affect our future economic growth.

Still, rising rates from such a low level have normally accompanied rising stock markets, not falling ones. And it is true that last week yields fell sharply again in a flight to quality as stocks declined. As a result, most bond investments rose last week.

Finally, Friday is the 31st anniversary of the October 19, 1987, market crash—a day I will never forget. While I had all of our clients out of the market on that fateful day, I visited with many of my brokerage friends at the time and found their offices in a stunned state. Phones were ringing off the hook, but nobody was answering them. They had no explanations to give.

Disturbingly, the price action this October is quite similar to that long-ago October’s. A new high has recently been hit, and a sell-off has followed.

This time, however, our indicators are not signaling a crash, only a retracement. And even though we are proud of our 1987 market call, in retrospect, it appears as only a blip on the long-term chart of the S&P 500 since 1928.

More worrisome are the two major declines of 2002 and 2007. These are the type of declines that continue persistently over more than a year and sap the life out of the stock market and the investors in it.

October is the most volatile month of the year. As a result, it seems like every October finds me doing the same thing—explaining a market correction.

But price declines are not the only characteristic of October. October is also known as the top turnaround month, when most market bottoms are formed.

Let’s hope that in December I can report the occurrence of a year-end rally, which also happens … most of the time.

Disclosure: No communication by Dynamic Performance Publishing or our employees to you should be deemed as personalized investment advice. Any investment recommended in this newsletter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. Dynamic Performance Publishing, its affiliates, and clients may hold positions in the recommended securities. Results are not indicative of holdings for clients of Flexible Plan Investments. Forwarding, copying, or otherwise duplicating this information for the use by anyone other than the intended recipient is expressly forbidden. These results are not representative of those achieved by clients of Flexible Plan Investments, Ltd. (NYSE:FPI) due to differences in security selection, timing of trades, transaction fees, and FPI’s management fees.