Market Risk and Investment Strategy
Any investment process must recognize the importance of risk. The best way to
appreciate the concept of risk is to compare it to the idea of probability. What is the
probability of making money? Or … losing money? If the probability is low, risk is high.
On the other hand, if the probability of making money is high, risk is low. Investors should
invest more money when risk is low because the probability of making money is high. This
is the time to be aggressive. On the other hand, when the risk is high, the odds of making
money are low. When the odds of making money on a specific asset are low, sell the asset.
Become defensive. Raise cash if you do not know what to do. Risk shapes a good
investment strategy.
As the environment changes, risk changes. In our game of investing, the other
players are the investors. The board, or table, is the market. Poker players know the
probability of winning changes as the game evolves. Realize the investment game is
dynamic, like poker or any other game of strategy. As the game is played, the odds change.
For instance, the odds of winning in team sports change depending on shifts in morale,
injuries, and how the other team plays.
An in-depth knowledge of the rules of the game helps to determine the risk of the
game and establish the chances of winning with a given set of strategies. Strategy
improves the odds of winning. As the game changes, we continually evaluate how risk has
changed and devise a new strategy. Poker offers a good analogy. Players do not bet the
same amount each time. They begin with a small bet because they do not know how their
hand will develop. They increase their bet only if their hand looks promising. Depending
on what the other players do, they raise their bet only if the odds of winning increase. If
the odds turn against them and the risk of losing becomes high, they fold their hand.
Investing your money offers similar challenges. Like it or not, we all participate
in the investment game. The economy and financial markets is the table upon which the
game is played. Investors continually change the risk/reward profile of each market by
getting new cards, raising their bets or dropping from the game. We need to adapt our
investment strategy and change the size of our bet (investment). Because risk changes
during the game, we change our bet accordingly. Adapting your portfolio to the changing
risk is the only tool under your control to avoid serious losses as in 2000. The major
advantage in lowering the risk, thus lowering the volatility of your portfolio, is to make
your returns more predictable.
When inflation rises, risk increases because the Fed shifts to a restrictive monetary
policy and stocks decline. When inflation declines, the risk in the financial markets is low.
Bond prices start going up, followed by a rising stock market. By looking at economic
indicators (like inflation), investors can assess the direction of risk and develop their
investment strategy.
Setting Realistic Objectives
In the last part of the 1990’s, the stock market rolled ahead accompanied by a redhot
economy and stimulated by excess liquidity from the Federal Reserve System. This
occurred at a time when Mr. Greenspan talked about ‘irrational exuberance’ and the Fed
was injecting liquidity into the banking system at rates between 7% and 15%. The Fed’s
actions ignored the average growth rate in liquidity since 1955 was close to 6%.
The excessive liquidity created a booming economy and a soaring stock market.
The main feature of the market in last part of the 1990’s was an enormous creation of debt.
The belief that 20-25% a year returns in the stock market was normal justified many
accounting irregularities. At that time, day traders used computers to trade online and
make thousands of dollars. Sadly, it was not their skills that made them rich, but a soaring
stock market. Traders believe their profits were generated by their skills. People speculated
with their retirement plans. Just throw the dart at the page of the stock market. It was
impossible to make a mistake. Everything was going up.
During those times, I spoke around the country about setting realistic objectives.
Many investors in the audience just smiled. The smiles of disbelief are hard to forget. My
presentations focused on prudent careful investing. Why should people be prudent and
careful if they can make 20-30% a year with some stocks doubling in a month? After
2000, stock prices suffered tremendous losses of 50-70%. This meant that losses could only
be regained if the remaining capital would double or triple.
If investors make 15% in the 1st year; then make 15% in the 2nd year; then make
15% in the 3rd year; but for some unexpected reasons they lose 15 % in the 4th year, the
return over those 4 years is slightly higher than 6%. All the efforts to make money in those
3 years are totally wiped out by just one loss of 15% in the 4th year. Look at it this way. If
you lose 50% of your money, you have to make 100% to come back and break even. If the
market provides 7-8% a year on average, it will take roughly 9–10 years before you break
even. Thus, the paramount strategy is to protect a portfolio against price drops. Any
decision to buy or sell must be geared to preserve your capital.
After 2000, investors realized some of their mistakes and the need to be prudent
with their money. This issue is important. When we set realistic objectives, we fight two
major emotional extremes: one is greed and one is despair. Around 2002, after a 70%
decline in the market, some people felt despair. Many decided to simply forget about their
investments. Further, they rationalized that investing was either not for them or they would
eventually recover. Instead, the savvy investor targets the golden median between greed
and despair. I call the golden median being realistic.
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