January 2, 2018
Written by Nathan Erickson, CFA®, CAIA, Partner and Chief Investment Officer
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There is a commonly used term in investment academia called the risk-free rate. It represents the rate of return an investor could earn if they were unwilling to take any risk. In the U.S. this is typically thought of as the yield on a U.S. Treasury security, under the assumption that the U.S. will never default on its debt. Depending on time horizon, this could be a 10-year Treasury, a 2-year Treasury, or the interest paid on an FDIC-insured bank account. In the current environment, the risk-free rate can be estimated at somewhere between 1.5% and 2.5%.
For most investors, that level of return is not sufficient to meet their long-term objectives. Instead they must be willing to take on some form of risk to earn a higher return and increase their probability of success. There are times, like 2000-2003 or 2008-2009, where the risk of most securities seems far too high and not worth any return they might provide. There are other times where most things appear to be risk-free and returns are easy to come by. 2017 may have been one of those years.
In terms of the U.S. equity market, risk was nonexistent. For the first time in history, the U.S. market had an entire calendar year of positive returning months. In fact, the 14-month period from November 2016 through December 2017 is the second longest streak of consecutive positive months since March 1958 through May 1959.
In our quarterly charts we shared how 2017 had the second lowest drawdown (decline from peak to trough) in the last 88 years at -2.8%. Another popular measure of risk is the S&P 500 volatility index, or VIX. VIX represents implied volatility, which is one component of how the price of an option contract is calculated. The higher the implied volatility, the more expensive the option. It is also termed the “fear gauge” based on the fact that as investors become more fearful, they are willing to pay more for an option contract to protect themselves from markets going down, all else being equal. While data on the VIX only goes back to 1995, recent levels in 2017 are the lowest we have ever seen. Not only did the market act risk free, it didn’t scare anyone.
The low-risk environment persisted beyond the S&P 500. Of the more than 16,000 market indexes measured by Morningstar that are based in U.S. dollars and report on a total return basis, 94% of them had positive returns in 2017. This includes all asset classes, sectors, sub-sectors, and regions of the world. To be fair, many investors owned securities in the 6% of indexes that experienced losses in 2017, such as managed futures, the energy sector, MLPs, and reinsurance. Regardless, most investors who had any kind of diversified portfolio made money in 2017.
From Risk-Free to a Minsky Moment
Most readers probably aren’t familiar with the American economist, Hyman Minsky. Dr. Minsky was a professor of economics at Washington University in St. Louis whose research attempted to provide an understanding of the characteristics of financial crises. His theories went unnoticed for decades until the 2008 financial crisis caused a renewed interest in them. At that time, a managing director at PIMCO named Paul McCulley coined the term “Minsky Moment”. A Minsky Moment is characterized by long periods of increasing value of investments, which then leads to excessive risk taking through leverage and speculation. Looking back at the period prior to 2008, we can see multiple occurrences of this, as the housing market was making everyone wealthy. The movie “The Big Short” illustrates the speculation that was occurring, where people were buying multiple homes at a time with undocumented mortgages, expecting to sell six months later for a profit. The housing market appeared risk-free.
We saw similar behavior in the dot com bubble when Enron employees put their entire 401(k) in company stock, or investors focused their portfolio on tech stocks. We are seeing it in small pockets today, as you read news stories of people buying Bitcoin with a credit card or a home equity line of credit. This behavior, called overconfidence bias, is something we’re all prone to, not just in investing but in all areas of our life. For example, in surveys approximately 93% of students say they are “above average” drivers, and more than 60% of faculty at large universities rate themselves in the top 25% for teaching ability, both factually impossible. However, the data is persistent regardless of who we are or the question that is asked; we all tend to overestimate our own abilities.
The appearance of risk-free markets encourages our overconfidence bias. Short-term success that we attribute to our own skill makes it worse. As journalist Jason Zweig stated at a recent conference, “There is nothing more poisonous to rational behavior than making a boatload of money in a short period of time.” Returns without volatility lead to more overconfidence, which leads to more risk taking, which may inevitably lead to another Minsky Moment.
Objects in Mirror Are Closer Than They Appear
This commentary is not intended to forecast the imminent decline of markets. In fact, looking ahead to 2018, there appear to be few headwinds to continued market growth from an economic perspective. Instead, the purpose of this commentary is to remind investors that, although certain asset classes and investments may appear less risky, their risk hasn’t changed. In reality, the risk of an investment is relatively constant, particularly over longer periods of time.
As advisors, one of our ongoing concerns is that we may not fully understand each of our clients’ risk tolerance. MRA Associates goes to great lengths to educate clients about the potential return distribution of their portfolio. We focus particularly on the worst moments, as these are the times where temporary losses can become permanent if the magnitude of decline is overwhelming. We know these “worst case scenarios” will occur at some point. What we don’t know is whether the level of decline in those moments is truly tolerable until we’re in that moment.
If losses in that moment are not tolerable and they lead to a change in investment allocation (which can mean anything from reducing equities to going to cash), the portfolio’s ability to achieve its long-term objective may be permanently impaired. Assessing risk tolerance and investment allocation based on recent market performance, and in a moment fraught with emotion, may cause greater harm than any other decision an investor makes. In that moment, the right thing to do is believe in the portfolio to which you committed and be patient for markets to recover.
Investors should look at 2017 in the same way as 2008. We have gone through a year where nearly all asset classes moved in the same direction, and where many of them behaved in an abnormal fashion. Reducing risk based on market performance in 2008 was a bad idea. Adding risk based on market performance in 2017 would be a bad idea. As we start the new year, we remain confident in the portfolios we have designed for clients. Remember the statement contained in every disclosure in the investment industry: “past performance is no indication of future results”.