October 4, 2017
Written by Nathan Erickson, CFA®, CAIA, Partner and Chief Investment Officer
To download a PDF version of this commentary, click here.
The Trade-offs of Investing
In Greg Mankiw’s classic textbook Principles of Economics, he outlines the Ten Principals of Economics, the first of which is that people face trade-offs. In other words, to get one thing that we want, we usually must give up something else that we want. Making decisions means trading one goal for another.
We face trade-offs during our lifetimes, from a very early age through our retirement years. In school, we often had to trade social time for studying in order to achieve better grades. As adults, we trade food for fitness, free time for family, or social time for career success. The hardest trade-offs are those where there is no clear good or bad choice, or where we don’t realize the benefit of our decision immediately – we may not know until far into the future if we made the best choice. For example, there is nothing wrong with buying an expensive new car today or continuing to drive the same car you’ve had for ten years, but you might be willing to continue to drive the old car if you thought saving the money could lead to a more enjoyable retirement.
copyright (c) 2017 Robert Leighton
Understanding trade-offs is a critical part of investing. Everyone who makes an investment decision should clearly understand what they are giving up and what they are receiving in return. In almost every case, fair trade-offs involve either giving up the liquidity (access) or safety of our money (or a combination of both) in exchange for a financial return. Anytime we see an investment that promises a financial return without having to give up one or both of those things, we get suspicious.
At MRA Associates, we believe the relationship between these trade-offs is fairly linear. In other words, as we trade more and more liquidity and safety, we should get paid increasingly higher returns. Investors always have the ability to control the amount of liquidity and safety they give up but, regardless of the amount, they should receive fair compensation. We get suspicious if we see investments that promise high returns but ask for very little in terms of the liquidity or safety of our money.
In most cases the trade-offs of our investment choices are relatively clear. If we are not willing to give up liquidity or safety, we can put cash in an account at the bank and we will receive little to no return. If we are willing to accept some illiquidity, but not give up safety, we can earn a little bit more in a certificate of deposit (CD), or Treasury bills, notes, or bonds. The more illiquidity we are willing to accept, the higher the yield on that bond and the greater the return. If we are also willing to give up some safety (i.e., take credit risk), we can buy a municipal bond, corporate bond, or high yield bond, each paying a higher rate of return as we transition from most safe to least safe.
The trade-offs in equities are clear as well. An equity investor has no pre-defined rate of return like a bond investor, and if a company goes out of business the equity investor who owns stock in that company is the last to get paid from any proceeds. The potential to lose money in equities is far greater than in bonds. Public equity markets create the appearance of higher liquidity; however, pricing is completely out of the hands of the seller, and stockholders are subject to many other factors that are out of their control, such as economic cycles and investor behavior. If an investor needs to sell a stock, in most cases he or she can at any time, at the price the market is willing to pay. If he or she is unwilling to sell at that price, the investor is forced to continue to hold the stock, and there is no assurance he or she will ever receive the price originally paid for that stock. This is very different from bonds, which have a stated value that will be repaid at maturity.
As investment markets evolve, so do the opportunities for trade-offs. Access to new asset classes and implementation methodologies create opportunities, but they also increase the level of evaluation required to make successful investments. Given recent events, reinsurance is a good example. MRA has been investing in reinsurance since 2012 and, until this year, it was an asset class that appeared to have very little risk with relatively high returns. The liquidity trade-off is similar to bonds, in that we are giving up immediate access to our capital, in some cases for a minimum of three months. The safety trade-off, however, is unique relative to bond and equity risk. Unlike equities, where prices can change on a daily basis, reinsurance risk shows up in moments, when there are events such as hurricanes or earthquakes. The remainder of the time, however, reinsurance appears risk-free. Equities and reinsurance may have the same average return over a period of time, but the path for each to achieve that return will look very different.
With non-traditional asset classes like reinsurance, we add an additional factor to the equation, which is comfort. Most of us have seen enough charts or have invested for long enough to know exactly how a bad year in equities looks and feels. In fact, some investors may even get uncomfortable when a bad year doesn’t happen for a while, in a way preparing themselves for what seems like the inevitable. When a bad year happens we certainly don’t enjoy it, but it makes sense in the context of investing. We understand that the risk of a bad year is the reason why we can earn higher returns than with cash or bonds.
With reinsurance, not only have many investors never experienced a bad year, it is nearly impossible to see one coming. When a bad year does happen, it is unexpected and even shocking, particularly when you’ve been lulled into a sense of safety after several good years. We have a tendency in those moments to become hyper-focused on the very short-term experience and lose sight of the longer-term trade-offs.
When we invest in reinsurance and other non-traditional asset classes within a portfolio, we are not only adding the attributes of that asset class to the portfolio, but we are also reducing the burden on other asset classes. We can look at this in different ways. More money in reinsurance is less money in equities, which is the largest source of risk for any portfolio. Today that may not seem appealing when equities have done so well over the last seven years. But we know a bad year in equites will come, and it has the potential to have a far greater impact on our overall portfolio than reinsurance ever could. Additionally, more money in reinsurance with expected returns of 6% to 8% means less money in cash or fixed income with expected returns of 0 to 3%. The low interest rate environment may persist for several years, which means money invested in cash and traditional bonds will add very little to portfolios after factoring in inflation.
As your advisor, we understand the trade-offs of using the non-traditional asset classes in which we invest, and the trade-offs of including them in client portfolios. If we are introducing non-traditional asset classes, we must commit to a higher level of evaluation and communication and, in return, we expect higher returns for client portfolios over the long term. If we do not find ways to offset the risk of equities or the low returns in bonds, we may have easier investment conversations, but it may cost our clients a higher probability of success of meeting their long-term objectives. Every member of the MRA team would agree that the effort required to find and evaluate non-traditional asset classes, incorporate them in portfolios, and defend them in the tough moments, is worth it if it leads to better outcomes for our clients.
In our view, clients experience better outcomes if they have a higher probability of achieving their long-term objectives with a more diversified portfolio. Over shorter time horizons, better outcomes can be less downside participation when equity markets experience substantial drawdowns. However, better outcomes are rarely outperformance of the S&P 500 when it’s performing at top speed. To increase the probability of success and reduce our risk to the downside, we must be willing to trade full upside participation. In those times, this trade-off can be frustrating; but time and again, history shows us that over the long term, the well-diversified portfolio wins out.