Investment Risk & Market Timing

“O Fortuna! Like the moon everchanging, rising first, then declining.”

- Carmina Burana, lyrics from O Fortuna

Risk is a part of our everyday life. When we get out of bed in the morning, there is a risk that you may trip by stepping on something lying on the floor from the night before. If you stepped a few inches on either side, you may be okay. Would you call it a risk that you stepped on a soft piece of foam that literally gave you a ‘spring in your step’? You are off to work on what is normally a 30 minute commute. On some days, the inevitable traffic jam makes your commute an hour long or worse, you may be involved in an accident or mechanical repair that causes you to miss work that day. That is certainly a risk, but is arriving to work within 20 minutes (instead of the normal 30 minutes) a risk? You take a well-deserved vacation to Las Vegas where you wager $50 on blackjack. Your risk is that you might lose all or a portion of the $50. What if lady luck shined on you that day and you made a $50 profit, so you walked away with $100. Is that a risk?

What do the above examples have to do with investing? Well, quite a lot because they are in stark contrast to how the financial world measures risk. The financial world defines risk in terms of variance (or standard deviation) from an “expected” return. If a broad equity index like S&P 500 is expected to return 8% a year with a standard deviation of 14%, that means, roughly two-thirds of the time, the annual return will fall between -6% and 22% and you can be 95% confident that the returns in any given year will be between -20% and 36%. That variance is collectively called “risk” or “beta” in the parlance of finance professionals. Since the market itself is used as a benchmark, the market beta is, by definition, 1.0. Any given stock’s or a segment’s (like small-cap stocks) variance is measured similarly and its variance divided by the total market’s variance gives us a beta value for that stock or segment. For example, the historical beta of U.S. small-cap stocks is about 1.2, which means it is 20% more volatile than the S&P 500 index. So, if you thought the swings on the S&P 500 returns are wide enough to give us an upset stomach, a 1.2 beta implies that the swings on either side are 9.5% larger (recall that standard deviation is the square root of variance).

You and I as investors don’t experience risk as the financial world defines it, do we? The downside is the only risk for us, the upside is the reward. Any return above the “expected” return is a reward for us and arguably, any returns that beat ‘safe’ cash investments may also be acceptable to some, so a large portion of the variance range of returns may not be ‘risky’ from an investor’s perspective. Naturally, the presence of an upside guarantees the presence of a downside. Herein lies the paradox for many investors who gauge the risk of an investment using beta. I submit that beta is inappropriate as a risk metric for most practical investors. If a highly volatile investment has gone down substantially (take the equity markets as of this writing as an example), does it mean that the markets are now more risky? Using beta as a risk metric would say that the market is just as risky when it was going up as when it is going down. However, the downside risk (the only risk that matters to investors) has actually decreased when the markets have declined significantly. India’s equity market lost nearly 35% in value so far this year, and China’s equity market has wiped out over half of the investor’s wealth so far this year. So, are China and India more risky or even equally risky to invest in now compared to last year? I would argue that that they are far less risky to invest today compared to last year for any long-term investor.

The same scenario applies in United States. Using Vanguard’s Total Stock Index ETF (VTI) as a proxy for the broader U.S. market, its current price of 61.5 suggests an earnings yield (the inverse of P/E ratio) of 7.93%. As of July 11, a 10-year Treasury Bond is yielding 3.96% and the 30-year bond is yielding 4.52%. Are stocks more risky now than bonds? Absolutely not! The stocks are priced very attractively for a long-term investor compared to other investments. Look back and do the analysis of the periods where the earnings yield on stocks was nearly twice that of bonds. In the following years, the stock market delivered substantial returns to the investor.

Yet, the financial press is screaming with headlines of risk in equity markets and with the dire status of financial institutions, equities seem to be the last place people want to invest. Wall Street Journal reports that of last week, investors have yanked about $39 billion from U.S. mutual funds and over $6 billion from ETFs – precisely the wrong moves to make when the market is priced so attractively. If you have additional money to invest and have a long investment horizon, now may be the time to buy equities or at least continue your periodic investments. Even if there is no additional money to invest, staying the course during times like these preserves the upside potential when the markets do turn around.

To those who seek the refuge of investment ‘professionals’ during times like these for trying to identify ways to eke out market-beating returns, I am reminded of this classic quote from William Bernstein (emphasis mine):

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends on appearing to know.”

It is tempting to think that if only we could sell out of equities just prior to or just after a bear market started and re-enter at the early stage of the next bull market….doing so would escape the 20% or so decline that even a diversified portfolio may endure in a bear market. It is important to remember how difficult it is to do that and get it even reasonably right. Even in strong bull markets, there are months with negative returns and conversely in bear markets, months with positive returns. To those who feel they can forecast market movements with any reasonable degree of accuracy, consider the following words from various experts at the end of the last major bear market. I have annotated actual market performance below these quotes in parentheses.

“I suspect 2003 will end up being the fourth consecutive down year for the first time since 1932.” – Jeremy Grantham, January 2003. [U.S. and many international markets delivered the best return in 2003 in hindsight over the last 8 years, with S&P 500 delivering 24.82% return including dividends]

“I do not believe a long term investor will make money in this market because it is a secular bear market.” – Felix Zeulauf, Barron’s, January 27, 2003 [From January 2003 till May 2008, which includes more than 6 months of the current bear market, the S&P 500 delivered a 10.71% annualized return including dividends]

“Soaring energy costs, the threat of terrorism, and a stagnant job market have sent consumers’ spirits plunging to levels normally seen only in recessions….consumer confidence level fell to 64 in February, lowest level since 1993.” - Wall Street Journal, February 26, 2003, page A3.
“Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds – including a hefty $3.7 billion just last week…” - Wall Street Journal, March 11, 2003, page C1.
[From March 1, 2003 till May 31, 2008, the S&P 500 delivered 12.23% annualized return with dividends reinvested.]

“These stocks are still way ahead of themselves. I am not sure we have seen the bottom. I think we could see new, lower lows.” - John Rutledge, Evergreen Investments, Wall Street Journal, June 16, 2003, page C1.
“Several important signals suggest that prices have at least topped out for the time being, and at worst are primed to back down….classic signs of a market top…” – Charles Biderman, President of a market-research firm, Wall Street Journal, June 26, 2003, page D1.
[From June 2003 till May 2008, the S&P 500 delivered 9.30% annualized return with dividends].

“Even some bears now acknowledge that, when they warned people to stay away from stocks one year ago they were wrong. But they insist that now, after the market’s big gains, it is too late to buy.” - Wall Street Journal, October 13, 2003, page D1. [For the period from October 2003 (after the big gain in 2003) till May 2008 which includes 7 months of the current bear market, S&P 500 delivered 8.7% annualized return].

Predictions, anyone? :-)