On Risk Taking

Risk Model: 5 - Beta up!

Lessons Learned in the Investment Trenches

“Investing is the only business I know that when things go on sale, people run out of the store”

Investment risk is not only a function of volatility, but of valuation. Most investors have forgotten this fact, including many of my former clients. Should it matter to the 40-year-liability pension fund what the 1-year return has been? If it's been a down year they should be happy to purchase risk assets more cheaply. But I learned long ago not to expect such a rational response, even from the most sophisticated of investors.

The financial meltdown in 2008-09 changed everything. The near-death experience of the financial system created a new 'bull market in pessimism' that persists until this day. Investors used the volatility spike experienced in 2008 to justify their reduction in risk appetite precisely at a generational low in valuation. Perversely, the response to this once in a lifetime opportunity was to sell, not buy. They responded to a four standard deviation volatility event by purging public equity allocations in an attempt to prevent another similar, although unlikely, occurrence.

It's ironic that the institutional investor, who should have the longest investment horizon, has forgotten the lessons of the past. The lemming-like rush to add expensive low-volatility strategies, highly sensitive to interest rates, has exposed the pension community to the valuation risk of a rising discount rate and its consequential underperformance.

Bonds, bond-like equities, even many alternative assets, have one thing in common, interest sensitivity. Similar to the drubbing they took in the late 1970s, a massive performance lag is lying in wait for the dividend hugging, risk-averse pension funds. I would have preferred that my clients maintained their prudent and highly diversifying allocations to high-beta cyclical resource equities but funds "de-risked" to appease their trustees' personal risk comfort level.

But how will these new allocation strategies perform in a different environment? When the market tone changes and market performance is influenced by rising inflation, a scramble will surely begin.

When will this occur? I don't know. But as in late seventies, there will be a shortage of investment professionals who even know what cyclical inflation looks like, let alone know what to do about it. Back then institutions scrambled to hire young, unproven analysts to help recommend hard asset stocks such as oils and golds to balance their bond heavy portfolios. I know, I was one of them.

History will repeat. I can't wait.