My last post on risk management was somewhat impractical. It was critical of the shortcuts we often take in analyzing risk but didn’t offer anything in the way of practical alternatives.
The theme of the last post was that in spite of the sophisticated-sounding calculations underlying most analyses, they are at best crude approximations. In general, these approximations (e.g. assumption of uncorrelated, normally distributed investment returns) make the world seem less risky than it really is.
So, what are we supposed to do about it?
- We should take even less risk than our statistical models indicate is acceptable, building in an extra margin of safety. For example, holding some cash reserves even if we have the risk tolerance to run fully invested.
- We should use leverage sparingly.
- We should not make overly concentrated bets. I’m not just talking about individual stocks here. The same goes for securitized asset classes like US large cap stocks.
- We should not have too much conviction in any given position.
Also, in theory, the more certain you are of an investment outcome, the larger and more concentrated you should make your positions. If you knew the future with total certainty, you would go out and find the single highest return opportunity out there and lever it to the max.
Given we live in a world where a 60% hit rate is world class, most of our portfolios should be considerably more diversified with considerably less than max leverage.
I don’t think any of that’s particularly controversial.
But I’m not just talking about individual stocks here. This goes for broad asset classes and the notion of “stocks for the long run,” too. I’m not arguing we should all be capping equity exposure at 50%. But it’s prudent to stress portfolios with extreme downside scenarios (this is unpopular because it shows clients how vulnerable they are to severe, unexpected shocks).
How robust is the average retiree’s portfolio to a 30% equity drawdown that takes a decade to recover?
For that matter, how robust is the average retiree’s portfolio to 1970s-style stagflation?
“It was so painful,” says William M.B. Berger, chairman emeritus of the Berger Funds, “that I don’t even want my memory to bring it back.” Avon Products, the hot growth stock of 1972, tumbled from $140 a share to $18.50 by the end of 1974; Coca-Cola shares dropped from $149.75 to $44.50. “In that kind of scary market,” recalls Bill Grimsley of Investment Company of America, “there’s really no place to hide.” Sad but true: In 1974, 313 of the 318 growth funds then in existence lost money; fully 123 of them fell at least 30%.
“It was like a mudslide,” says Ralph Wanger of the Acorn Fund, which lost 23.7% in 1973 and 27.7% more in 1974. “Every day you came in, watched the market go down another percent, and went home.”
Chuck Royce took over Pennsylvania Mutual Fund in May 1973. That year, 48.5% of its value evaporated; in 1974 it lost another 46%. “For me, it was like the Great Depression,” recalls Royce with a shudder. “Everything we owned went down. It seemed as if the world was coming to an end.”
Are we building portfolios and investment processes taking the possibility of that kind of environment into account?
Are we equipped psychologically to deal with that kind of environment?
I conclude with this evocative little passage from George R.R. Martin:
“Oh, my sweet summer child,” Old Nan said quietly, “what do you know of fear? Fear is for the winter, my little lord, when the snows fall a hundred feet deep and the ice wind comes howling out of the north. Fear is for the long night, when the sun hides its face for years at a time, and little children are born and live and die all in darkness while the direwolves grow gaunt and hungry, and the white walkers move through the woods.”