A Few Thoughts on Risk

Early on in this pandemic, we promised to share the lessons we learned. Without hesitation, the number one lesson learned is humility—with respect to both the progression of the pandemic and its economic consequences.

We were surprised by both the magnitude of the drop in March and the speed of the market’s recovery. As of the end of July 2020, The U.S. stock market was up 2.06% year-to-date (based on VTSAX). Considering that consumer spending is 70% of the economy, we ask ourselves how is it possible that the aggregate value of American companies remains intact with a tripling of the unemployment rate and a 9.5% shrinkage of GDP in 2Q/2020? Of course, none of this market recovery would have happened without the massive intervention by both the federal government and the Federal Reserve. In the classic valuation equation for stock prices, it’s difficult to argue that expected future profits are now higher than pre-COVID times, but we can posit that the risk-adjusted discount rate is lower, thanks only to Uncle Sam. More on this later.

COVID has forced us to reexamine our views on risk, particularly with respect to investing. Let’s take a step back and ask the fundamental question, “What is risk?” Volatility is certainly an important consideration because it speaks to the likelihood of investors abandoning their current strategy (usually to their own detriment). The possibility of shortfall (the failure to meet an investor’s required rate of return) requires careful consideration. The minimization of volatility (i.e., investing in Treasury bills and CDs) invariably magnifies the risk of shortfall. Another important risk is the failure to achieve the returns offered by the financial markets. This may result from neglecting to properly diversify, behaving poorly, or simply paying high costs (don’t get us started on that one).

A useful definition of risk arises from considering the purpose of investing—the postponement of consumption. When we invest, we give up the possibility to spend today in the expectation of being able to spend more in the future. As we recently heard from Prof. Ken French, “Risk is the uncertainty around lifetime consumption.” Note that in addition to money spent or given away during one’s life, consumption includes bequests upon death.

French’s elegant definition extends well beyond investments. For example, a fire insurance policy, even with a negative expected return, is a sensible and necessary purchase because it eliminates the uncertainty of the financial devastation from having to replace your home in the event of a fire. This definition also puts an investor’s human capital into the proper context. A higher certainty of income (e.g., a tenured professor) can facilitate the acceptance of more volatility in his/her investments and vice versa.

So how much uncertainty has COVID added into our lifetime consumption? On the one hand, Uncle Sam has shown that he can make us whole in our investments through massive purchases of securities to support prices. However, we must never forget that risk and return are not only related, they are inseparable. Reduction in investment risk entails reduction in future expected returns. A lower discount rate applied to future profits equates to a lower expected future return. In no place is the reduction in future returns more apparent than longer term Treasury bonds where a 10-year commitment will currently get you a whopping 0.55% yield to maturity. In light of all the extra government spending (not to question the necessity thereof), the prospects of higher future taxes (both federal and state) increase the uncertainty of our future consumption.

Make no mistake, we are in a tough investment environment, especially for those who are looking to generate income. As tempting as it may be, we do not advise reaching for income into high yield (junk) bonds. With respect to stocks, we continue to believe that the majority of investors are best served by index funds that track the global financial markets. For some investors, it makes sense to emphasize companies characterized by a low cost per dollar of book value (value stocks) and/or high profitability. If you would like to discuss any of these topics further, please reach out to us at advisors@clarityca.com.