Why Avoiding Risk Is Much Riskier
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Investment commentators and the financial media tend to discuss risk on a regular basis, but is there any real consensus as to what they mean? The general types of investment risk are well known. Market risk reflects the inevitable price churning of securities in response to changes in investor sentiment, or fluctuations in the fortunes of either the economy, specific sectors or individual corporate entities. Interest rate risk naturally affects the valuation of all investments that make fixed income distributions. (Or in the case of the US Treasury bond market, it seems to have been largely discarded.) Inflation risk threatens to erode the real value of either income or assets. Credit or default risk again naturally affects the valuation of debt instruments. Currency risk threatens the value of international (non-core) investments. Market timing risk is essentially just a variation on market risk.
A growing consensus seems to have formed within much of the institutional community that all risk is bad and should therefore be avoided at all cost. This principle appears to have caught on with UK pensions institutions who have decided, with some government interference, that the bulk of their assets should be invested into the bond market irrespective of the fundamental attractiveness of that market, particularly in relation to the fundamental attractiveness of UK equities, where non-domestic institutions have reaped the reward of the market's recent rise.
This principle also seems to have been behind much of the recent capital surge into hedge funds, which have evidently been marketed as low risk if not riskless investments. But short term market risk is inevitable, and should be practically irrelevant to all investors with a long term investment horizon. We have suspected for some time that given their increasing focus on micro-managing short-term downside price volatility, many institutions have lost the plot when it comes to attempting to deliver meaningful longer term returns. Furthermore, those institutions have merely replaced one type of risk (short term market risk) with another, which we could term the risk of herd behaviour allied with margin compression. Arguably, hedge funds themselves have merely replaced one type of risk (market risk) with another - overdependence on financial modelling.
Nor is this misallocation of intellectual resources restricted to investment institutions. In its Economics focus ("Beware the bubbles"), The Economist this week singles out the central banks, which appear to be, in time-honoured fashion, fighting the last war. While the Bank for International Settlements (BIS, the "central bankers' bank") has argued that America needs to raise interest rates more aggressively in order to restrain risk-taking in financial markets and borrowing by households, the Federal Reserve "has rejected the advice of the BIS for many years, insisting that the main job of a central bank is simply to control inflation. The risk is that in single-mindedly looking out for inflationary icebergs, a central bank will fail to spot the rocks that lie dead ahead."
Whenever institutions shift their focus away from core activities (in investment terms, from trying to deliver meaningful longer term returns) and toward micro-managing shorter term risks in search of a supposedly easier life, crisis ensues. We recently cited Andy Kessler in the context of US corporations smoothing shareholder expectations:
"In order to smooth AIG's reported earnings, Hank Greenberg entered into a questionable swap with Warren Buffett. It kept his stock up then, but now that investors have figured it out, his stock has gone from $70 to $50 and he has joined the unemployed. He should have let his stock trade wildly..."
The baneful trend toward meeting quarterly expectations - created by the baneful folk who work on Wall Street and happily bandwagoned by the media - has led to a wholly artificial cult of the short term and further infantilization of the markets. Its latest manifestation has been in hedge funds expected only ever to deliver positive months and which face significant redemptions in the event of even the most trivial loss.
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In trawling through Google in search of information on Bayesian priors, we stumbled across the following article: "Moving beyond the Precautionary Principle: the case for unbiased risk management". The author, Fred L. Smith Jr., was speaking at a seminar by 'International consumers for a civil society', but much of the piece has a relevance to financial markets:
"Nothing is more risky than insisting on avoiding prudent risks... Safety is not "chosen" as the Precautionary Principle advocates would have it – rather (to quote the late political scientist, Aaron Wildavsky) safety is found in experience, in learning to live with the risks all about us. Paradoxically, only by developing dangerous products and technologies – that are nonetheless safer than existing alternatives – does the world become a safer place...
"Those advocating the Precautionary Principle seem to favour a safe world. They should rethink this strategy – the search for safety today as always requires that risks (prudent to be sure) are taken. The greatest risk is to seek a safe world – rather than a safer world."
Perhaps the biggest single risk factor facing individual investors today is agency risk. Future pensioners, for example, are having their future affluence jeopardized by the variously informed actions of professional investment managers who have no skin in the game, so to speak, and who are therefore comfortable misallocating long term savings into investments that carry little apparent short term risk.
The flip side of this decision, of course, is that pension funds are sacrificing longer term returns on the altar of perceived political correctness. The suitability of hedge funds for individual investors is a topic for another day (suffice to say we prefer to view the hedged investment approach as a "Stay rich" rather than a "Get rich" methodology), but where hedge fund managers deserve praise rather than opprobrium is in the alignment of their economic interests with those of their investors by the simple mechanism of being co-investors. When traditional (read: heavily constrained) investment managers operate in the same way, we may see a reduction in the inherent risk of the agency effect.
One senses, however, that the absurdity of constrained investment will be more widely acknowledged before then, and that within a fairly short period of time, the only investment mandates that mean anything will be those that come with an absolute return label.
Tim PricSenior Investment StrategisAnsbacher & Co Ltd
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