One of the first investing lessons I learned was, not to lose money. Not only is it mathematically a problem, as losing 50% means you must gain 100% to return to even, but it has lasting psychological impact that can cause all sorts of opportunities for misjudgment: pervasive fear that leads to selling at the wrong time, a reluctance to buy at the right time, or buy enough, just to name a few. It is nearly impossible to foretell how we will react, therefore if one is interested in earning a respectable return (greater than the risk free return of short-tem treasuries) we must develop what Howard Marks describes as, “risk Intelligence.” It’s the investors’ job to understand, recognize and control risk. I frequently revisit informative writings in order to ensure that the compass needle is pointing in the right direction. This letter was inspired by an article that Howard Marks wrote some time ago, Risk and Return Today.
“The Fed has spiked the punch bowl. You can get drunk on easy credit and once you do you start doing things drunk people do. We’re not there yet, but we’re a little tipsy. People should start thinking about not driving.” – Howard Marks
We have had more than one conversation lately discussing whether or not investors should be more aggressive right now. We agree with the notion that investors should be constantly evaluating and discussing risk, as we are not attempting to be completely risk averse. We are attempting to be intelligent on when, and where we take risk. With the risk free rate yielding less than 1% and interest rates pressuring market values, many have exited safe haven investments. This, after nearly all risky assets have boomed in market value since the 2009 lows. Investors are choosing riskier alternatives to achieve more return.
Academicians represent this normal risk/return choice using the capital market line. It demonstrates that everything else being equal, the more risk you take, the more return you can expect.
The mistake that many make is assuming that the return outcome tells the whole story. If return was the only consideration, we would all invest in coin flipping with a 100% return on each occasion, as if we have a special insight on how to properly pick a coin flip. Of course the risk of losing it all with a coin flip highlights that we really do consider risk when making capital allocation decisions. The best investors instead look at investments with a probabilistic approach, where the possible outcomes are not binary (heads or tails) like a coin flip, but rather the numerous outcomes are represented in a probability distribution.
The four investments in the above graph have a range of outcomes with the riskiest investments on the right of the graph. A risky investment on the right may return less than an investment toward the left of the graph.
Let’s follow a progression of how this applies today. The following is a representative example of several asset classes and their respective annual returns in a normal environment.
Unfortunately, remember today that the risk free rate has been reduced to less than 1% which shifts our entire line downward. This is representative of what occurred as the Federal Reserve reduced the risk free rate and began its asset purchase program of Quantitative Easing (QE).
Now let’s consider that investors have followed suit and began exiting the assets on the left and began allocating to investments on the right. This flood of investment capital reduces our respective returns and has flattening effect on our line. Our risks haven’t necessarily changed, but with the financial crisis “solved” our attitudes toward risk have changed.
The effect is that when considering the negative possible outcomes of assets on the riskier end of the scale, we begin to see negative returns. That may be unacceptable to most investors. The returns available at that point are certainly not worth the risks.
The market reinforces this lesson every so often. In the worst of these cases, investors are overly optimistic, oblivious of risk and more than willing to venture into areas that they know very little about. Although things can change very quickly, we are not there today. A healthy skepticism still lingers.
We have discussed our areas of interest this year, but it is becoming more difficult to find interesting areas to allocate new capital. In the absence of a balanced risk/reward equation, we will always choose safety first. Investors often feel that they have to have a great idea. It is unwise to think that all investment opportunities are created equal and that all points in time will offer an equal risk/reward opportunity. Balancing intellectual and emotional self awareness is paramount as we enter a market (domestically) that no longer offers non-speculative returns. If markets continue higher without substantive value (ie. earnings growth), we will continue to sell assets on the right side and buy assets on the left side of the capital markets line.
“They’ve (stocks have) moved a long way, they were very cheap five years ago, ridiculously cheap, and that’s been corrected. They are probably more or less fairly priced now. We don’t find bargains around…we are having a hard time finding things to buy.” – Warren Buffett