The stock market has been down four whole days in a row and media is all abuzz. Interest rates are on the rise as market participants continue to worry about the Fed’s tapering off of quantitative easing. The rate on the ten-year Treasury has now gone from 1.5 percent to 2.8 percent. That is a big rise, and of course as rates rise, the value falls. This brings us to the concept of risk in investing and how it can be managed.
The first step in managing risk is defining it. There are four primary definitions in the financial world and which one you use will have a big influence in how you manage your investments. I will call the first definition the legal claim definition. Different investment vehicles provide different claims on assets. Bonds, for example, are simply loans, and loans are generally backed by some form of collateral. The bondholders of a corporation have a claim on the company’s assets should the company fail and go into bankruptcy. Stock is ownership in a company and should a company fail, the owners will get only what is left after all the bondholders’ claims have been settled. In this view bonds are always safer than stocks.
The problem with this definition is that legal rights do not trump the laws of physics. It reminds me of a former colleague, an attorney who served as in-house counsel at Invesco. He and I would often go to lunch together and in doing so we would have to cross a few streets. He had a habit of walking right out in front of oncoming traffic. I would tell him not to do it and he would respond, “I’m in the crosswalk and have the right of way.” I would often tease that I would be sure to tell everyone that when I was speaking at his funeral. The legal rights to assets mean little if there are no assets to be had, and perhaps less obviously they also mean little if there are more than enough assets to cover all claims and leave the owners with a windfall. This is a poor definition of risk in the real world, even though it dominates popular investor education materials.
The second definition is that risk equals volatility. This is the dominant view of the investment world. Risk is defined as standard deviation and/or Beta, both mathematical terms which measure respectively the absolute and relative price movement of financial assets. Under most circumstances stock prices move more than bond prices, so this view also leads to the conclusion that bonds are always safer than stocks. The problem here though is that volatility goes in both directions. Do we care equally about upside volatility and downside volatility? Most investors I know do not. This leads to the phenomenon of investors saying that they want to take on more risk when the market is going up, then less when it starts going down. I would argue that any useful definition of risk would not change with the direction of the market.
The third definition is relatively new and it is exclusively used within the investment world. This is the risk known as tracking error. It is the measure by which a fund manager’s return differs from the market benchmark by which he is judged. This measure is completely useless to the client as what it really measures is career risk for the professional. The idea is that as long as one looks like the benchmark, the client won’t fire them. It is one of the most damaging results of relative return-focused investing.
Finally there is what we believe to be the real definition of risk. Risk is the probability of losing money (or not making enough) over a given investment horizon. In this definition there are no absolute relationships because the safety of an asset is not primarily determined by legal structure or price volatility and it certainly has nothing to do with the relationship between it and some arbitrary definition of “the market.” The risk of losing money is determined by the price an investor pays. If one pays more than what an asset is worth, then that investor is likely to lose money. If one pays less, then that investor is likely to do well. By this definition bonds can be riskier than stocks.
Third quarter to-date through this past Friday the S&P 500 is up 3.4 percent and the Barclays Aggregate Bond index is down -0.90 percent. Which looks more attractive to you? When bond yields are as low as 1.5 percent for a ten-year obligation then the risk of owning them is high, if you consider risk losing money or at best not making enough. With rates at that level the best case scenario is that one gets the 1.5 percent gain. That won’t pay for much of a retirement.
We have been saying this in our forecasts for some time, and of course earlier this year we moved to an under-weight to bonds and diversified our bond exposure to try to mitigate the risk of rising rates. We didn’t do that because we are clairvoyant; we did it because we understand that risk is price. When bonds are that expensive, it is best to sell them and own something more reasonably valued; in this case, stocks.
Seth Klarman, the famous hedge fund manager, is fond of saying that Wall Street has the habit of taking the safe label and putting it on risky assets and taking the risky label and putting it on safe assets. This is because too many have the overly simplistic view that risk is somehow predetermined by legal structure or volatility. Prudent investors understand that risk is price. Any asset can be safe if the price is right, and likewise any asset can be risky if the price is wrong. Recognizing the difference is the essence of prudent investing.
Chuck Osborne, CFA