Redefining Risk
by Richard
Selling risky assets is itself a risky strategy….long term.
There is a paradox to falling security prices. We loved these stocks a year ago, when they reached their all time highs.
And we are selling them indiscriminately now that they have fallen 40-50%.
Because they are perceived to be risky.
Hold on a second….how can an asset that is selling at half off be as risky as it was when it was floating inside the leveraged economy bubble?
Risk manifests itself in many guises in our economy.
Specific security risk says that any individual stock could take a big tumble. Of course, that’s why we gravitate towards diversified stock portfolios, or let our fund managers do it for us. Once we have 20-25 stocks, we have insured against company risk.
Systemic risk is the risk inherent in the market as a whole. The past twelve months have been highly instructive and illustrative of this risk.
Volatility risk is a longitudinal measure, comparing expected returns to actual returns over time. The correlation over time is that higher returns are a function of increased volatility.
No pain..no gain.
The thundering herd is now running hard from Volatility Risk and its cousin, Systemic Risk.
And they are running into the trap of inflation risk and opportunity cost risk.
Inflation risk is not so swift in its retribution, but is devastating over long time periods. It now takes $11 to purchase $1 worth of goods based on the 1926 dollar, when Ibbotson began tracking securities returns.
Inflation will benefit the borrower more than the lender, since the borrower takes down real money, and repays later in devalued monopoly money.
Inflation is why governments and businesses and households become heavily indebted. It goes hand-in-glove with high leverage. But now we are in for a prolonged and painful unwinding of leverage.
Instead of borrowing funds to harness the power of inflation, we will be forced to save. Saving funds makes you a lender (to banks and other depositories), so now you are the one who will be stuck holding the diminishing asset.
Opportunity cost risk is the position the public will be in when markets revert to the norm (the upward pointing right leg of the U or V shaped recovery), because they won’t believe it while it is underway.
They will believe it at the next market top, to repeat the dreary cycle once again of buying high and selling low.
The point is this: There is no avoidance of risk…
…only the choice of whichever risk preference you choose.
Age will tilt your selection. The young who have decades to go until retirement should choose volatility risk, to obtain the best long-term returns. They need to be fully invested for the long haul.
Even those at or near retirement would be wise to split the difference, and hold half their assets hostage to volatility risk.
The old joke was the wage earner’s lament about having too much month at the end of the money.
What’s not so funny is having too much longevity at the end of the money.
November 14th, 2008 at 5:47 am
I keep good stocks where they’re at a high, because seeing them in my portfolio makes me feel smart.
I sell them when they’re low because looking at them makes me feel stupid.