The Envestnet Edge, September 2017
Time to take a (measured) risk?
Astute investors know that buying when others are fearful can be a good strategy. Despite remarkably low market volatility, investors continue to avoid risk. This month, we examine previous periods of risk and investor behavior, when investors discarded normal valuation measures, threw caution to the wind, and suffered the consequences. But those periods have few parallels in today’s market environment, suggesting that carefully introducing some risk into portfolios may be timely.
Risk. Mention the word, and many investment professionals pause. Traders, hedge funds, and a few quantitative firms and their algorithms may love risk. But these days, the preponderance of investors, advisors, strategists, and their clients—not to mention the individual investor—see risk as a negative to be avoided. And that is why, dear readers, it may be time to consider adding some to clients’ portfolios.
All of the attendant disclaimers should—and must—accompany that statement. Adding some risk wisely does not mean turning a conservative portfolio into an aggressive one, or tossing best interest out the window. It does not mean advising clients to take half of their assets and put them in bitcoin. Nor does it mean ignoring real, actual risks in favor of rank speculation and greed.
It does, however, mean considering investments whose success is predicated on the continued stability of the financial system and the continued evolution of global commerce. In short, considering risk in today’s climate might simply mean investing as if the world is not on the verge of some crisis.
Risk now, risk then
Measuring the market’s appetite for risk is not science. One popular gauge is the level of volatility in the market, measured by a basket of futures known as the VIX (CBOE Volatility Index), which often is referred to as “the fear gauge.” In spite of global crises, such as North Korea, domestic political sclerosis, and popular sentiment that has been trending negative, market volatility has been remarkably low. In fact, it has been on a steady decline for a few years, after staying elevated in the years following the 2008-2009 financial crisis.
Volatility measures suggest that both investor appetite for risk and investor fear are muted. One would think that as market players become less concerned, they would behave in the opposite fashion by loading up on risk. It certainly was the case in the late 1990s and again in the mid-2000s, and to some degree it was the case for the years after 2008, when a select number of funds made substantial sums of money trading financial instruments and derivatives keyed to volatility.
Today, however, even though volatility is muted, investors continue to pursue investments that they see as safer. Despite equities having a very strong year, fund flows into them are negative. While there have been a number of weeks with strong inflows into US equities, almost every week has been positive for US bonds, with billions of dollars flowing into Treasurys, even as rates sag and lag and refuse to budge much above 2.5%.
Fund flows are a decent proxy for investor preferences, and this year they paint much the same picture as in the past years. Even plain vanilla equities—not small caps, biotech, emerging markets—are less in favor than government bonds, regardless of the fact that equities of all flavors have been doing much better for the past few years. The same is true of higher risk bonds: high-yield bond prices have barely budged, which means that demand may be stable but hardly substantial. Compare today’s risk appetite with that of the late 1990s or the mid-2000s, when appetite for return trumped concerns about risk. Investors poured into more and more speculative equities in the late 1990s and into more and more esoteric debt and derivative instruments in the mid-2000s, especially those tied to the red-hot housing market of those years.
In the late 1990s, as many will recall not so fondly, valuations were not just stretched. In many instances, they were non-existent. Given a proliferation of tech companies without discernible earnings, and stocks going up 10X, investors took to new metrics other than price-to-earnings (P/E), because the P/E ratio for many of those issues was zero. Instead, metrics such as price-to-growth were floated as alternatives in assessing possible future earnings. In that sense, one just cannot compare market valuations today with market valuations on the Nasdaq in 1999. The appetite for speculation then versus today was many times greater.
The same can be said for the mid-2000s. Equities were also surging then, but the entire financial system was benefiting from excessive liquidity brought on by lax leverage standards at banks, which had become complacent about risk. Numerous funds as well as traders were allowed to trade 10X or 20X (or more) of their capital, which, as long as it worked, drove up asset prices of homes, equities, and derivatives. In the years after 2008-2009, a combination of intense and even excessive regulation, and a recognition at many financial institutions that excessive risk imperils their survival, has led to much less leverage and much less exposure. Here too, today is a far less leveraged climate.
None of this is to say that there isn’t risk, especially unknown risk, in the financial system. But on most measures, one just cannot equate today with the late 1990s or the mid-2000s. In fact, one cannot equate today with 2009-2012, when the potential unravelling of the European Union was putting extreme strain on global financial systems, and the massive liquidity being injected by central banks was potentially bolstering asset prices. Now, with modestly rising rates in the United States, along with an unwinding of that liquidity, today looks even more stable than just a handful of years ago.
And yet, appetite for even modest risk is hard to find on a mass scale. Risk itself has been defined down to include almost any investment that isn’t perceived as safe and that could under various circumstances lose value rapidly. When investors contemplated adding risk in 1999, that meant getting a piece of the Pets.com IPO; today it means putting money in a US small cap fund.
Given investors’ paltry appetite for anything that has a whiff of risk, and given how crowded the “safety” trade remains, it is an opportune time to consider investments that, relative to one’s current allocation, appear riskier. What that means specifically depends entirely on the nature of one’s portfolio and individual needs and goals. For a 30-year old looking to amass capital, it might mean small caps, high-yield debt, and emerging markets equities or individual investments in newer companies with less tested models. For a retiree, it might mean more exposure to US large cap stocks via a diversified equity index fund. Risk is a relative concept in most cases, and contemplating adding a dollop here and there will have a different complexion depending on one’s age and goals.
It’s an old adage—repeated by everyone from financial advisors to Warren Buffet—that buying when others are fearful and selling when others are greedy is usually a good rule of thumb. From sentiment to actual flows of money, investors today are closer to fearful than to greedy, and at the very least, they are cautious and timid. That may mean that assets considered even modestly risky might be bought for less than they would be otherwise.
In short, with volatility extremely low and markets stable even in the face of global uncertainty, now is the time to assess whether and how much risk to take on. Doing so can be, well, risky, but not doing so could be riskier if long-term returns fail to keep pace.
Investors continue to shy away from risk, recalling the lessons of the 1990s and 2000s, and more recently, the market meltdown in 2008-2009. Fund flows into equities are negative, as investors look to bonds to bolster portfolios, suggesting they may be timid and cautious. As the financial system continues to stabilize and global commerce continues to evolve, adding some risk to portfolios may be prudent. But that doesn’t mean making drastic changes from conservative to aggressive portfolios. Rather, advisors should remember that controlled risk is different from speculation, and carefully guide their clients in selecting investments that are consistent with their age, needs, and goals.
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