Smarter people than I have said that investors should think of themselves as managing â€“ not a portfolio of stocks and bonds, but rather — a portfolio of risks. Each of your account holdings represents a risk of loss. And while plenty of theories propose how to better mitigate risk, ultimately, the unexpected is what does the most damage.
Adherents of flawed investing theories, such as asset allocation, diversification and Modern Portfolio Theory, advocate what appears to be decent ways to control risk. By spreading your investment dollars around to several different asset classes and among several different holdings within each class, they believe you are better able to offset the most commonly occurring risks. To an extent, they are right. In the absence of a better set of rules, these theories are accepted as the best.
But frequent readers of this column know that I have argued against this type of thinking before, so Iâ€™ll not go there again. But what I would like to discuss is how many investors fail to plan for the unexpected risk — the bolt out of the blue that too few look for in advance.
Yes, I know what you are thinking. How can we know what to look for in any â€œunexpected eventâ€? That one-in-a-million occurrence — like 9/11, the Russian bond collapse, the Mexican peso crisis or the savings and loan debacle — caught most investors by surprise. Black Monday in 1987 is another good example.
Of course, for each of these cases, except for 9/11, some will argue that investors should have seen those events as more possible than anything they had factored into their allocation set. But regardless of the past, tomorrowâ€™s unexpected event is lurking out there and may once again catch investors on the wrong side of the risk spectrum.
One strategy you could use is attempting to see trouble looming and position a portion of your investment dollars into risk-protection strategies. For example, if you think the housing market, which seems to have blown through the â€œbottomâ€ that some predicted would appear early this year, might bode ill for stocks, you could hedge your stock market exposure. Adding cash or bear market mutual funds could help.
You could also make a list of potential trouble spots and rate them according to the likelihood of their occurring. Assign a value for how much negative exposure your portfolio would have, should that potential event occur. Obviously, this is a complex endeavor!
Yes, I do maintain an informal list of what could go wrong, starting from with the notion that our government is now bankrupt on to the eventual cost of losing two wars; from the falling value of the dollar and what that could do to the bond market to the massive losses now being absorbed by some on Wall Street from their bad bets on mortgage bonds and derivatives. The list is long, and each possible occurrence could prove destabilizing.
But too often, the risk that few think about is what happens, and that is costly to investors who were looking the other way. I am now reading a very good book, Nassim Nicholas Talebâ€™s The Black Swan, which discusses what could happen to investors with this type of unexpected event.
Talebâ€™s describes a â€˜â€™Black Swanâ€™â€™ as having â€˜â€™three attributes: unpredictability, consequences and retrospective explainability.â€™â€™ He shows how some really smart people, like the Nobel Prize winners at the helm of Long Term Capital Management, suffered massive portfolio losses when something unexpected occurred. They failed to model their allocation set for the likelihood of an occurrence that seemed too small to worry about.
Investors in technology stocks should have foreseen the â€œunexpectedâ€ early in the year 2000, but many investors suffered significant losses on what seems now obviously possible in hindsight? Of course, some expected the usual 20% correction, not the eventual 80% drubbing that the Nasdaq 100 endured before finding the bottom.
How many real estate investors are learning the hard way that overpaying is never a good idea for illiquid investments like homes, now that those investments find no offers at any price? Of course, that situation, too, should have been foreseen as a real possibility. It seems that most investors who lose money over time have become victims of risks that were amazingly obvious?
But how do we plan for unexpected risks? And how do we offset them? Letâ€™s look at some examples. The very idea that this country must borrow over $2 billion/day from foreigners should be setting off alarm bells all over Wall Street. What is now developing in the housing market should also alert investors to a heightened sense of risk. When the best-paid hedge fund managers are taking significant losses, what are the chances that the rest of us are now exposed to higher risks?
In his book, Taleb explains that these â€œoutlyingâ€ events will do the most damage to investors. Most of us never think to plan for events that we consider having small potential for happening. He argues that the well-used bell curve provides false comfort to portfolio managers everywhere, since outlier events happen more often than the popular models plan for. The previously mentioned blow-up at Long Term Capital Management is a case in point.
But how do we plan for something bad that is yet to happen, when we have little idea of what that could be? Perhaps itâ€™s easier to do than most think, using a simple metric that, to my utter astonishment, most investors use infrequently. Employing the basic concept of valuation is a basic tool that is almost absent from todayâ€™s markets.
In one common practice, hedge fund managers use computers to spot stocks that are rising, without regard for their valuation. Two stellar examples include two closed-end mutual funds, the Cornerstone Total Return Fund and its sister fund, the Cornerstone Strategic Value Fund. Both sell at premiums of more than 50% of their underlying values!
Why would anyone pay that kind of premium for any basket of stocks? Especially when that basket looks much like a plain vanilla S&P 500 index fund when you check out the top holdings in each fund! The major holders of these funds are reportedly large hedge funds of the â€œquantâ€ variety — those who spend almost no time considering the fundamentals. Should an unexpected event happen, do these high-priced investments look especially vulnerable to suffering large losses? I surely think so!
But letâ€™s look beyond those fund examples. The S&P 500 sells at an average price to earnings ratio of about 18, while the Dow is slightly less expensive. The Nasdaq 100â€¦well, who knows what its average P/E is — with all the â€œinnovativeâ€ accounting games played there.
But itâ€™s not just our domestic markets that are soaring, despite fundamental reasons why they should be more subdued, with the potential that too many investors will sell foreign stocks before they sell the more well known domestic stocks and funds.
If the S&P 500 or the Dow sold at 10 times earnings, we wouldnâ€™t have so much reason for concern. We could rely on the underlying value of our holdings — knowing them to be properly priced for both good and bad times. We donâ€™t know whatâ€™s around the next corner, but with stocks, bonds and so many other investment assets selling at premium prices, investors can suffer much damage.
But, how good can we feel about being loaded up on gold, energy and international bonds–if worse comes to worst? Actually, I feel pretty good about these holdings, with my allocations in bear market mutual funds.
Who knows what the next unexpected event will be and when it will come? But one thing I do know is that with markets priced as they are today, more down-side potential exists than up-side potential. And the known risks can, just as easily as the unknown, turn the markets down.
I canâ€™t think of a better time than now to be defensively positioned!
Have a great week.
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.