Risk, Uncertainty & Just Maybe Survival

 It is quite fine to chase and expect returns, after all, that is one reason we invest, It is however important to understand the risk we are taking to generate the returns we expect. We take a look at risk and try to understand the best way to approach taking risk in this current volatile or at least uncertain market environment.

​We’re all familiar with the notion of ‘high risk, high reward’. This week we would like to take a step back and disentangle that adage and what it just might mean for portfolio’s and investing in the current environment. We shall start by defining risk and, believe it or not, it is frustrating the number of times that both professionals and the general public get it wrong. Risk simply put is the likelihood of some event taking place before an investment matures and as such risk constitutes both upside AND downside. Here it is also important to distinguish risk from uncertainty and the best quote we can give is from The Economist’s ‘guide to investment strategy’ which illustrates it with the following example:

‘Gambling on tossing a fair coin constitutes risk as the outcomes and their probabilities are fully known, even though the actual result of the toss is not. Being hit by meteorites, abducted by aliens or something similar while tossing said coin...is uncertainty.’

​And herein lies the first point about this strange dichotomy between the euphoric markets and the polar opposite commentary that comes in the media. Anyone who says that we are about to enter a recessionary period soon is firstly unaware of historic expansionary cycles following a major downturn. Think back to the decades that followed the Great Depression or the economic expansion following WWII. In that instance, the number of GI Joes that came back from the war added to the labour force and the subsequent decades created vast demographic changes, added to the labour force (baby boomers) and productivity growth. However, this came to an abrupt halt when in the 1970s the piper was paid in the form of increased inflation not to mention the sheer amount of political changes that took place. We can draw many parallels between what occurred during that time to the age we live in today. The catalysts today, however, are rather different, namely the fruition/commercialisation of the major technological innovations taking place and being implemented (the investment for which took place in the decade leading up to the dot-com bubble). Just as back in the late ’60s, investors and policymakers seem to be exceptionally underprepared for things to come should a repeat of the past occur (i.e. a resurgence of inflation or geopolitical upsets).

Indeed we should be more concerned about political uncertainty more than anything else at this stage, market risk as it stands is fairly well priced in. On a PE multiple basis American equities do not look to be too expensive and disparate from their historic norms (15x earnings) and European equities/emerging markets look downright cheap. So then what seems to be the problem?

We would suggest that here we need to bring in uncertainty and our inability to accurately price that in. As suggested before, market prices reflect expectations of future growth and current value (that is literally all there is to it once you strip out any nefarious dealings). To illustrate this point, think about how we value a stock like CBA, on a fundamental basis we look at what their balance sheet looks like, maybe price in growth prospects and risk based on past behaviour and a finite set of events from happening. Uncertainty came in the form of a royal commission that rather took people by surprise (in retrospect it seems easy to conclude we could see it coming but three years ago but not really with a coalition government in power), once the event has happened it becomes a risk and we can price that in and maybe even the ramifications as they unfolded. So what is our point exactly? 

The first point is, that as investors we need to be able to have some way to hedge uncertainty, not just understanding the market risk of something or using a pre-defined set of likely events and allocating based on this. We need to be fluid enough in our portfolios to be able to adapt quickly should a left-field event take place and be vigilant enough to try and continuously look for them. Just to be clear, we are not advocating the use of structured products, although that could be one avenue to go down towards, especially for someone with a long-standing portfolio that cannot move due to capital gains implications. We are more talking about the ability to move across asset classes in a fluid manner by being fairly diversified in the first place but having the ability to change weightings as contexts evolve. Take, for example, the TAMIM Alpha Fund portfolio which has a predefined allocation towards both growth equities and value companies. Through the use of put options to hedge downside risk (where we would effectively insure against market draw downs of greater than 10-12%) we effectively were able to sail through the December quarter and redeploy aggressively as the growth stocks especially tended to be the ones that get sold of aggressively first. The portfolio was effectively able to 1) make it through a significant event bruised but well enough; and 2) most importantly take advantage of the new set of circumstances that the event created; creating a new mix and asset weighting. 

From an asset allocation standpoint, it is undoubtedly true that equity market returns have done well for the past decade and this has in no small part been helped by monetary policy (which we would say dislocated them and this has been a global phenomenon). But this creates an issue in and of itself. No, we don't think the markets are overvalued (maybe priced in to capacity but not overvalued yet), but what happens if and when an uncertain/unforeseen event rears its head. An escalation of the trade war for example or, god forbid, another short-term contraction in the economy, with monetary policy already easy there is very little leeway for us to use the same tools as last time. For monetary policy to be effective in the event of a significant contraction, the central bank would at the very least in our opinion have to have the ability to cut 300-500 basis points based on past history. This is certainly not possible in an era of easy money. The only way around it would be to have more rounds of QE which unfortunately will not be so easy to fly in the current political environment. The only other tools we have would be direct fiscal stimulus or, increasingly likely, helicopter money whereby rather than buying things on the open market policymakers would effectively create money and hand it directly to the end consumer.

The above case is certainly what we are all unprepared for. The next market event (a result of uncertainty) we can say with fair probability will have inflationary implications and very few have priced that in as a risk.

While we may disagree with the notion that there is to be a recession anytime soon, we would suggest that there is not enough awareness by investors for left-field events. And those events are likely to crystallize risks previously unforeseen but would likely be inflationary. So here is our second point, at some point debt is going to matter and cash flow will mean something. The pendulum will swing and it will swing quickly. Going back to the comparison with the 1960s, it was also a decade where corporate profits rose with relatively little inflation in developed markets and steady growth in equity and asset markets. Come the 1970’s we all know how that unravelled. 

This is what we do need to account for. It is time to start thinking about ways to hedge portfolio’s and think about those events which have little likelihood of happening but could have far-reaching consequences should they eventuate. 

At TAMIM we are firm believers in the notion that the basic premise of investing should not be the rapid accumulation of vast riches (we shall leave that up to the punters) but rather the markets simply offer an avenue with which to sustain and, at the very least, preserve a standard of living. With that in mind, we would suggest a few rules of thumb:
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1. Have the flexibility in portfolios to make tactical allocations (one way is growth vs. value);
2. Value will come back and cash flows will matter (be ready for that) and high dividend yielding stocks should still be the vogue for a significant chunk of the portfolio (with tactical allocations to growth based on changing monetary environments);
3. Hedge for uncertainty and the only way to do this is to think about how your portfolio would react in extreme scenarios (i.e. think as extreme as another GFC or even more creative); and have some allocations as insurance against it. Rule of thumb, in an inflationary environment, commodities, energy and materials are the ones that do well. By the way, equity markets are also a hedge against inflation in and of themselves.
4. If you have to look for income outside of equities, have it at the very least indexed against inflation or actively managed. And if you have a preference for bonds, make them shorter-dated.