Let’s Talk About Risk
By most measures we’re experiencing the longest bull market in our history, starting in March of 2009 and briefly dropping by 30% in March of 2020, before recovering after the shortest bear market ever. As a result, we’re sharing the marketplace with a generation of investors who have never experienced a protracted bear market. These newcomers tend to have a very aggressive attitude toward risk, and according to Jason Zweig of the Wall Street Journal, this cohort of investors may have moved from risk-taking to risk-seeking behavior.
As investors, we recognize that risk is unavoidable. If we seek the safest investments and keep our money in cash or treasury bonds, we take the risk that inflation will erode our purchasing power. There is a continuum of risk from investments with lower returns and low volatility, to those with potentially high returns and much higher volatility, which could leave us with steep losses in any given market period. Seasoned investors endeavor to establish a balance between risky assets that should do well in an accelerating economy, and less-risky assets such as investment-grade bonds, which tend to perform well when the equity markets are flagging. We re-balance between asset classes in order to be net buyers of assets when the price of those assets is low, and net sellers when the price is high. Over the long term, this is a proven strategy for building and maintaining wealth.
In our view, the current problem is that we have so many investors whose experience does not include the long term. For instance, there are over 20 million new non-professional investors who have entered the market since the start of 2020, according to Devin Ryan of JMP Securities. They are encouraged by no-fee trading, social media investment sites, and enticing new trading platforms. These relatively inexperienced investors believe that the market decline and recovery of 2020 has taught them that the market rewards patience, which it does. But frankly not much patience is required when the market recovers so quickly, hitting new highs just 126 trading days after the low in March of 2020. It’s hard to predict how these untried investors will react to a protracted bear market.
Young investors may reasonably maintain a high risk tolerance, as they have a longer time horizon than those of us who are more seasoned. The question is whether they understand the risks they are taking, and whether they have a realistic strategy for building wealth over time. For those who are new to investing but not so young, it’s important to consider how their investment time horizon affects their risk tolerance. For any serious investor, it’s crucial to understand the difference between a risk that’s necessary and appropriate, and one that’s superfluous. To develop this understanding, investors must learn to recognize whether they are being compensated for the risks they take.
Newer trading platforms like Robinhood design their interface to mimic a video game, which means there is more adrenaline and less analysis than may be appropriate for sound investment decisions. The company is now launching a marketing tour of college campuses, offering promotions and giveaways if students will sign up using a school email address. The platform also promotes options trading, a complex and risky strategy which young investors increasingly embrace.
Robinhood says they are trying to “meet the next generation where they are,” and to help them start investing young so that they may enjoy the benefits of compound returns over a long period of time. This is a laudable goal, but to accomplish it they would need to encourage young investors to have patience, do their analysis and rebalance their portfolios periodically. Unfortunately, the game-like interface emphasizes acting promptly, trading often and “winning.” We know that trading often does not lead to better performance: https://empowermentfinance.com/blog/dont-chase-the-bus/ Until recently, the Robinhood platform tossed electronic confetti when a user placed a trade. This is simply the wrong approach for building substantial wealth over time, which if done well is a disciplined and somewhat tedious process. You win, but it takes a long time, and there is no confetti.
We’re also seeing increased interest in high-yield bonds, which are low-rated securities that also go by the name “junk bonds.” These bonds are typically issued by companies with significant debt relative to their earnings, so they are rated below investment grade. This year has seen record issuance of high-yield bonds, and investors frustrated by low interest rates are eager to buy them. What’s the downside of higher returns? Higher risk of default, and higher correlation with stocks, which is exacerbated in a declining equity market. But many investors don’t realize this, and many new investors were not in the market in 2008, when high yield bonds declined 37%, almost as much as stocks.
In our portfolios, we hold investment grade bonds, rather than high-yield bonds, as a balance to equities. While these higher-rated bonds are not currently providing much yield, they typically perform well when the equity markets decline. As we mentioned, high-yield bonds are more correlated with the equity markets – when stocks go down, in most cases high-yield bonds also decline. Unfortunately, it’s also common for the correlation between high yield bonds and equities to increase when the equity markets fall. In other words, just when you need your bonds to balance a decline in equities, you find that high-yield bonds become increasingly likely to decline along with stocks. This gives you the opposite result of a properly constructed diversified portfolio, which should include assets with low correlation. You may see a bit more yield from these junk bonds at the outset, but you lose the protective feature of a low-correlated asset, which is our main reason for having bonds in the portfolio.
We’re in an economy with record low interest rates around the globe, providing a tailwind for equity returns. To the new investor, this time of brief bear markets and quick recoveries may feel as though it’s a lower-risk environment. Like a pleasant day on the ocean, it seems like a nice place to take on risk, earn some outsize returns and crank up our yields a bit, because nothing really bad has happened lately. Long-term investors should know there are storms coming, and structure portfolios accordingly. Inexperienced investors should focus on understanding their own goals and risk tolerance, and on developing a disciplined analysis and trading practice that will get them through tough times as well as good times.
