In recent posts (here and here) I explored my view that today’s markets are systematically mispricing risk. My analysis isn’t exactly rocket science. So why does this mispricing persist? Why does everyone shrug their shoulders and say, “well, there is no alternative,” versus simply dialing back their exposures or hedging out some of the tail risk? At the very least, investors could increase the discount rates used in their valuations to correct for ultra-low riskfree interest rates and build in a greater margin of safety.
So why don’t they?
I would argue that more than anything, it is business and political pressures that drive this behavior. Importantly, I don’t believe this mispricing of risk is irrational. Rather, I believe decisions that seem rational on a micro level have led to irrational behavior in the aggregate. Investors are simply behaving how they are incentivized to behave–as a herd.
Here are my reasons:
Institutional investors must remain invested. If you are a mutual fund manager or a hedge fund manager or venture capitalist, good luck explaining to your investors why you are sitting on a portfolio that is 40% cash. Many investors are loathe to stick with a manager who sits on a cash hoard for an extended period. Particularly in a buoyant market where cash will drag on returns. There is a sound rationale for this: the investor is perfectly capable of allocating to cash or hedging market risk on his own. Why pay some asset manager fees to sit on cash? While this makes plenty of sense from a business perspective, it makes no sense at all to an investing purist. The purist takes risk when the market is rewarding her for it and pares risk when the market is not rewarding her for it. Portfolios should be positioned more aggressively when markets are dislocated and prices are bombed out. They should be positioned more conservatively when valuations are high and expected returns are low.
Institutional investors are afraid to look different from their peers. Career risk drives a great deal of behavior in financial markets. It is the reason so many mutual funds look so similar to their benchmarks. This positioning makes no sense to a purist concerned with absolute returns. Yet it is perfectly rational for the mutual fund manager who will be fired if he drops into the fourth quartile of performance for a trailing 3-year period. Likewise for pension funds and endowments with trustees who may be penalized politically for contrarian positioning.
All investors have return hurdles to meet. If you are an individual or pension fund there is a certain rate of return that will allow you to fund your projected future liabilities. If you are an endowment or foundation there is some spending rule governing portfolio withdrawals, usually based on long-run capital market expectations. Altering these hurdles is a big deal. Reducing expected returns means pensions and individuals will have to save more to fund future liabilities. Endowments and foundations may have to cut financial support for certain programs. This can be psychologically devastating for individuals and extremely embarrassing for institutions. It is a powerful incentive for investors to take a “glass half full” view of the future, even if it is ultimately self-deluding and counterproductive.
Perhaps the most significant advantage you can get in the markets is what Ben Carlson calls organizational alpha. Put simply, this is the flexibility to do what others can’t, or won’t, as a result of business and political pressure. It is the freedom to switch off the autopilot and deviate from the pre-established flight plan.