The truth about “risk” is that the term should be defined differently for each investor.  However, the reality is that many of us talk generally on the subject and rely on industry dogma and buzz words instead of developing a deeper understanding of what risk actually means to us as an individual.  Most, it seems, define risk using the text book method devised by academics, take for example the Sharpe ratio or standard deviation.  However, as a long-term investor, I find that these metrics can be challenging to use at times and question whether or not many of us are making Himalayan miscalculations when it comes to investing.

Taking a closer look.  Mainstream quantitative methods calculate risk as a function of the historic oscillations of the market prices of stocks.  Meaning, the risk of an asset traded on public markets is determined by the past investment decisions of active buyers and sellers in the marketplace.   This measurement does not reflect the product of primary research performed to assess the intrinsic value of an asset. Instead, the assumption is made that markets operate efficiently, that buyers and sellers act rationally based on all available public information, and this affords market participants the opportunity to capture the risk of an asset e.g. stock, indirectly without necessarily having to know much at all regarding the operations of the underlying business.  Makes sense…right?  Allow me to explain differently.  Risk is measured by what other people, who you don’t know, have done in the past for reasons that you are likely to never know.

Question: What does it mean when no new information is made public for a company and people are still buying and selling, pushing a stock price up and down?  Answer: Investors buy and sell for a variety of reasons that may have nothing to do with the underlying value of a business because in many cases a manager may not be concerned with the underlying operating assets of a business.  Think market technicians.  So the buying and selling of a stock may be largely driven by traders who are only looking to capitalize on psychological characteristics of other market participants within the same stock, not concerning themselves about the details of the underlying business that a ticker symbol may represent.

Now, let’s say there is new information released about a company.  For example, a company has decided to stop paying dividends, and since the announcement the volatility of the stock has increased. In this example, let’s assume the shareholder base rotated since many of the original fund managers coveted the stock because their clients crave dividend issuers as a source of current income. Should the volatility generated by the rotation of a shareholder base be considered risk?  What if the reason the company planned to stop the dividend payments was to buy back shares of their own stock, and that this was a far superior and tax efficient way of allocating capital in your opinion? The risk profile to you has decreased, while for others, the risk profile has increased as investors spend the next couple of weeks buying and selling shares to reposition their portfolios after the news.

When fear, born out of concern for increased volatility, begins to infect a stock you own and there is no news that is substantively negative that would affect the operating future of the underlying business, shouldn’t you buy more shares?  This simple concept, often discussed, that is so easy to understand and yet so incredibly difficult and counter-intuitive to implement can elevate an average long-term investment performance to a great long-term performance by a disciplined investor.

 

Different Model of Risk:

Let’s start with psychology, since this is no doubt a major contributing factor to volatility in capital markets. The human mind learns best when taking cognitive breaks from mundane tasks and subsequently exposed to new experiences only to return to a task then having this cycle repeat itself.  There is a growing body of scientific evidence that supports this view. Let us keep this concept in mind while we think of the systems in place at large asset management firms where teams of analysts, who are experts in the industries they cover, pitch ideas to portfolio managers for ultimate inclusion into a fund.

The thinking seems logical, a team of experts rolled under one fund structure will trickle-up their best ideas to a fund manager for inclusion in a portfolio.  This may make sense on the surface, however I have my reservations.  For one thing, working day in and day out looking and doing the same stuff goes counter to our biology.  Our experiences are limited to a small world, when we lack the intellectual freedom to pursue other interests, challenges and curiosities in different industries.

This, from what I understand, stymie’s new neurological connections within our brains and in turn hampers professional development.  Think being so bored at work that it is actually painful.  Then think being so bored and taking a break and doing or learning something new and interesting then coming back to the original task.  You are refreshed.

Science aside, bureaucracy is another major issue. Ideas must be pitched to a manger by an analyst.  So here, workplace politics, administrative tasks and power point presentation skills are critical for success. If an analyst can successful navigate these waters there is still one more hurdle that effectively stonewalls great ideas.  Many times a good investment idea can only have a small weighting within a portfolio.

Why? Because tied to order management and decision support systems at many of the largest billion dollar asset management firms is a compliance system that can and will preclude a manager from increasing a weighting in a particular stock or sector by more than a certain number of basis points relative to a benchmark.  This is called closet indexing. So that great idea gets lost in the weeds of over 500 positions with only the slightest of portfolio weight adjustments.  What is not lost is the management of risk relative to a benchmark, and this is what keeps the lights on at work.

The Way It Is:

So there you have it, an inefficient use of intellectual capital coupled with closet indexing leading to undifferentiated products that charge, at times, high fees for near average performance.  I believe that this is risk to individual investors.  Why?  Because they can simply buy a low fee index ETF to accomplish the same thing.  And keeping your fees low is key to compounding money over the long-term and that’s what investing is about.

 

 

 

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