Why most investors have no idea how much risk they’re taking in the market
Published: Friday, 6 March 2020 | 11:53 AM ET
By: Ivory Johnson, CFP, ChFC, Founder, Delancey Wealth Management, LLC
The Lower East Side of New York City is like a lot of neighborhoods in most American cities – we had working class families, a few ballers and your run of the mill gangsters spread out amongst us. And because I was once young, I recall going to parties in dangerous locations because for one reason or another they turned out to be the most fun.
Granted, I knew I was rolling the dice, but there was no way for me to quantify the level of risk I was taking. Unfortunately, and invariably, somebody would be reminded that cars get broken into, wallets are stolen and sometimes nine millimeters of inhumanity would ruin the evening for some unlucky party goer.
One could make the same case for the level of risk investors take with their portfolio, as the math used to measure volatility is obscured by suspect and antiquated theories. The predominant pillar of this veiled black box is standard deviation that manifests the bell curve said to illustrate the normal distribution of outcomes. An example of the methodology might deduce that 90% of men stand between 5 ‘4 and 6 ‘2 inches tall. In financial risk terms, that means there’s a 5% chance of a man being shorter than 5 ‘4 or taller than 6 ‘2. The average height may be 5 ‘9, except the markets don’t move in a linear fashion.
When you apply this strategy to the financial markets, it might give one the impression that there’s a 90% chance that the stock market will return, for instance, between -20% and +20%. Moreover, if you were to mix stocks with different characteristics, so as one zigs the other zags, a prudent investor can reduce the odds of an extreme event.
The problem is real markets are wild, and like turbulence, the risk can happen in clusters. Experience tells us that prices do not follow the proportions of the bell curve. In fact, most changes are small and an extremely few are large and unpredictable. Additionally, prices are not independent, being influenced by yesterday’s activity, something not captured by the math.
Mathematician Benoit Mandelbrot studied daily index movements of the Dow Jones Industrial Average from 1916 to 2003. He describes in the book “The Misbehavior of Markets” that financial orthodoxy would have us believe that there should have been 58 days when the index moved more than 3.4% when in fact there were 1,001 such days. The index should have swings of more than seven percent every 300,000 years, even as the 20th century saw 48 such occurrences.
Forget the 2008 housing crisis for a minute – sometimes the damage from sudden volatility is averted. Long term Capital Management was a hedge fund that boasted the architect of the Black and Scholes model among their ranks that could allegedly identify securities that were mispriced.
Sure enough, LTCM had profits of 42.8% in 1995 and 40.8% in 1996, but by 1998 the math stopped adding up. In August of 1988 the Russian government defaulted on its bonds, prices of other securities became dependent on each other and the market contagion forced the Federal Reserve to nudge reluctant banks to bail the fund out to the tune of $3.625 billion.
It seems that some investors are impervious to the risks they take in their portfolio, going to wonderful parties in the wrong parts of town. I have no idea what impact stock buybacks, a bad call by the Fed or decelerating GDP growth could have on stock prices, nor when the impact might occur, if ever. The coronavirus is an event risk that no model can account for, causing the disparity in outcomes to expand.
What I suspect, however, is few investors give it a second thought and an evolving strategy to measure these risks with a repeatable process is warranted given the possibilities the market has demonstrated exist. In that sense, investors should speak with their advisor about his/her approach to risk management, ensure that it accounts for the realities of our day and forge a better path forward.
And in case you missed it, be careful where you park your car.
Ivory Johnson, CFP®, ChFC
Delancey Wealth Management, LLC
20 F Street, NW, Ste. 750
Washington, DC 20001
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