Rethinking risk

Market participants all want the same thing: the best possible return at the lowest level of risk. How you go about securing that, however, is often a source of disagreement. While you might think investment is a black-and-white affair, the assumptions that you use to underpin your calculations can have a decided influence on your decision to invest – or not.

Of course, future returns are never certain (and even in fixed income markets, bond holders could default). But add changing macroeconomic variables, irrational markets, unrealistic expectations and investor emotions into the mix, and getting to certainty becomes even more difficult. No wonder many investors settle for the ‘obvious answer’ – whether this is picking last year’s winner or simply following the crowd. Using such decision-making shortcuts can often lead investors astray, and while there are always risks to doing so, we believe the current market environment has elevated the risks of taking such shortcuts even more.

Markets have become bifurcated, with investors clamouring to invest in the strategies that have proved successful in the past, and so it becomes a self-reinforcing cycle, with popular winners continuing to win. The longer the cycle continues, the more foregone the conclusion becomes in the popular mind.

What is risk?

Risk is often defined as the potential to lose money, but this view can be extended to the possibility that your return expectations won’t be met. The concept of risk is intimately tied up with the concept of uncertainty (and, at a more human level, disappointment). In a world of deeply bifurcated markets, the definition of risk for many seems to have shifted to the ‘risk of missing out’.

Exuberant and irrational markets create opportunities for patient investors. Part of our investment process is testing the assumptions underpinning market behaviour, so we can look for the opportunities others are missing out on. These are typically found in the uncrowded sectors of the market. Currently, markets are defining risk very narrowly as the ‘risk of missing out’ and more specifically, the ‘risk of missing out on a repeat of the returns from a narrow subset of assets’ (read more about this in our latest Angles and Perspectives).

Risk assumptions affect how we view opportunity too

Being careless about the assumptions that underpin your estimations of fair value and future returns will sway your investment choices. Therefore, we believe that investors should be very clear about what their assumptions of the future imply, to minimise the risk of being disappointed later.

Perceived ‘low risk’ assets like US government bonds are offering very little yield, while the S&P 500 is at generational extreme ratings. Previously when the S&P ratings were in similar territory between 1998 and 2000, investors had to wait 13 years before seeing a capital gain (and weather two corrections of more than 45%). With ratings already at such extremes, investors should question how much longer such conditions can persist – and what it could mean for portfolios if their underlying assumptions were proven wrong.

More worrying for us, however, is that current risk perceptions are blinding investors to the areas of the markets that do offer the potential for exceptional future returns, even when we apply currently very negative assumptions that underpin popular narratives. Thus investors are not only investing into a very narrow subset assets driven by a fear of ‘missing out’, but they are also avoiding investment into broad range of assets based on prevailing narratives that these assets are ‘too risky’. As we methodically unpack the narratives around what is ‘too risky’, however, we often find they stubbornly overlook any mitigating factors, and are based on deeply held narratives of fear. The risks of investing in SA Government Bonds are widely discussed (and potentially overstated) while the appeal of high yields and steep yield curves are overlooked. SA Inc shares are all assumed to be write-offs based on poor economic prospects, when these companies have proven they can fare well despite the local economy and even when these companies do not depend only the South African consumer.

In starting this article, I noted that investors want “the best possible return at the lowest level of risk”. Your ability to do so as an investor, however, will depend on your ability to correctly assess what risk is. Get that fundamental insight wrong, and your ability to invest successfully in the long term, will be severely compromised.

ENDS

Article sourced from PSG Angle

The PSG Angle is an electronic newsletter of PSG Asset Management