ABNORMAL RETURNS

McGraw-Hill

Contents

Chapter One

Risk is a four-letter word. Like other less polite four-letter words, it is hard to imagine living without it. An understanding of risk is crucial in any attempt at becoming a competent investor. While risk may be unavoidable, its definition is, at best, fluid. Risk can mean different things to different people at different times. When investors discuss investing, they say "risk and return." Risk first, return second. Likely they say it this way partly because risk rolls off the tongue better, but also because risk represents the fundamental building block of finance and investments.

If risk and return are a matched pair, why then is so much emphasis laid at the feet of risk and not returns? Returns are in a certain sense easy. Returns are visible. Whenever we turn on financial television or access the Internet, we are confronted with stock prices. Returns are not all that difficult to measure. In the vast majority of cases, to calculate returns we only need the change in price of a security along with any dividends or interest paid along the way. We also have pretty good return measures going back decades, if not centuries, across a range of countries and asset classes.

As transparent as returns are, risk is that much more opaque. If you ask most people what is risk in regard to investing, they would likely mimic the dictionary definition: "the chance that an investment (as a stock or commodity) will lose value." There is no database where we can look up historical levels of risk for any security. We can't even state with any certainty the current risk of any particular security.

This lack of precision in the definition of risk left an opening for academia. Academic finance was forced to come up with its own definitions of risk. Depending on how you look at it, finance took a more mathematical route in defining risk. In the most established model of finance—the capital asset pricing model (CAPM)—risk isn't some measure of potential loss; rather it is measured by volatility, or the degree to which a security's price fluctuated in value. Finance types will recognize this as a gross simplification of the CAPM, but the fact is that volatility takes into account all price fluctuations, not just those that are negative.

In other models that followed the CAPM, there is also a linear relationship between risk and return. The higher the expected riskiness of an asset, the higher the expected return on the asset. Pretty simple. This is embodied in the phrase "nothing ventured, nothing gained." It is important to recognize that we are talking about averages here, the theory being that, on average, higher risk is compensated in the form of higher returns.

Much of academic finance in the past three decades has been dedicated to showing the many ways in which the CAPM fails. Academics have created newer models that add additional factors to explain security returns, based on the assumption that these factors proxy for various kinds of risk, which presumably are compensated for on average and over time. In that time, academic finance has begun focusing on measuring risk when asset returns, and the overall economy, are performing poorly.

This academic conception of risk is very different from that of many investment practitioners. This difference is palpable in this quote by James Montier, who writes, "Risk is the permanent loss of capital, never a number." Those investors who look at securities on a case-by-case basis—or in the parlance of the industry, from a bottom-up perspective—hew much more closely to our intuitive sense of the word risk.

These investors, often value investors, see not a linear relationship between risk and return but rather an inverse relationship. Those securities that are the least risky have the highest return potential. This is because these securities have been beaten down and the risk has been wrung out of them. In short, these assets have much less farther to fall and are therefore less risky.

Even in this world, the conception of risk is still opaque. No security comes attached with an estimate of its risk. Analysts are forced to make an estimate of a security's fair value. However, these fundamental investors feel that if they focus on securities that trade far below their fair value, they work within a margin of safety.

If you are able to unearth enough securities trading with an adequate margin of safety, you can generate returns both in excess of the market and with less overall risk, the idea being that this buffer between what a security's true value is and where it is trading will make up for any errors the investor makes in judgment or analysis. The concept of a margin of safety puts the risk management process at the forefront of investing. Noted investor Howard Marks makes the point by saying, "Skillful risk control is the mark of a superior investor."

We would all like to be superior investors. However, as discussed in the introduction, that goal may be a stretch for many of us. You can bet that successful investors, like Howard Marks, got to that stage in part by focusing on risk management. Getting from one period to the next with your portfolio largely intact should be the first goal of any investor. In investing, like in a marathon, you can't finish the race if you don't pass each checkpoint along the way.

What should be clear is that whether you conceive of risk in this fundamental framework or in the academic sense, risk is unavoidable. Some people never take that first crucial step to becoming investors because they are paralyzed by the fear of investing. They feel that if they don't step off the sidewalk, they cannot be at risk from oncoming traffic. Unfortunately for them, they have not taken into account the possibility of a car making its way onto the sidewalk.

This somewhat gruesome analogy is important because financial risk is everywhere. It is explicit in the investments we already own. It is implicit in the trade-offs we make by choosing to invest or not invest. It would be great to believe otherwise, but a lifetime of investing is also a lifetime of risk taking.

There Is No Such Thing as a Risk-Free Asset

Risk taking does not come naturally to most people. For every inveterate risk taker, there are a handful of individuals happy to stay as far away from risk as possible. For the rest of us, risk taking is much more of a learned response. In fact, there is evidence of a large genetic component in our willingness to take on financial risk. This mismatch between our innate desire to take risk and our need to take risk to generate returns represents the lifeblood of the financial industry. Much of what the financial industry does is to create vehicles that mitigate risk. At its worst, the industry tries to fudge or hide the risk of certain investments altogether.

Sometimes society as a whole decides it is in our collective interest to mitigate risk. One of the most visible instances is FDIC insurance. Bank deposits for individuals are now guaranteed up to $250,000 per bank. The government does this so that individuals are not at risk to the failure of a bank, in addition to trying to prevent bank runs. The FDIC is proud to note, "Since the FDIC began operation in 1934, no depositor has ever lost a penny of FDIC-insured deposits." That guarantee, however, is not absolute. In the midst of the financial crisis, the limit was increased to what it is now. There is nothing that prevents, however difficult politically, a future government from reducing the limit.

The point is that in the above case, government—and in other cases, the financial services industry—acts in a way to try and entice risk-averse investors to take on investment risk. A perfectly reasonable way of doing this is through collective vehicles such as mutual funds and, more recently, exchange-traded funds (ETFs). To a person, investors recognize that investing in a portfolio of stocks is less risky than investing in any individual or handful of stocks. By mitigating the risk of an individual stock, the hope is that a fund investor is able to enjoy a general rise in stock prices over time.

For most this is a welcome development because the stock market is a cruel place. The high-profile Dow Jones Industrial Average recently celebrated its 115th anniversary. It might surprise you that only one company, GE, has been in the index from the outset. Clearly permanence is not a feature of the equity markets. We need not look out over an entire century to see equity risk; we need only look a year or two in advance.

In 2001 Enron Corporation went bankrupt. It is not news that companies go bankrupt. Companies large and small go bankrupt all the time. What is news was that Enron had been one of the largest companies in market capitalization in the United States and had been named for six years running as "most innovative" among Fortune's Most Admired Companies. This stunning turn of events is a lesson in the risks of any individual company, even one as widely held and admired as Enron.

Market participants recognize that equities, individually and as a whole, are risky. Academics can debate the precise types and amounts of risk, but suffice it to say that few today believe that equities are risk free in any sense of the term. The picture when it comes to fixed income is very different. Risk in the fixed-income market is a different beast altogether.

In the bond markets, investors are worried about two things: "When am I supposed to get paid back?" and "Am I going to get paid back in full, and if not, how much will I receive?" Everything else really stems from these two questions. The bond market, compared with the equity market, is therefore more up front in its approach to risk taking (and risk avoidance).

Despite its many flaws and its woeful performance in light of the financial crisis, the rating agency paradigm is still the way in which the bond markets stratify risk. At the very bottom of the risk scale are bonds issued by the U.S. Treasury. These securities are assumed by most market participants to be risk free, despite recent political turmoil that threatened the U.S. Treasury's ability to manage the debt. Every other bond is subsequently priced in reference to Treasuries.

If the fixed-income story ended there, it would be a straightforward one. On average, lower-rated bonds default more often than higher-rated bonds, and fixed-income investors on average price bonds accordingly. So when a company as big and as high profile as General Motors declares bankruptcy, it does not come as that great a shock to the markets.

Other times investors can be caught flat-footed. One could argue that the onset of the financial crisis was caused by the rapid decline in Lehman Brothers' liquidity position and its subsequent bankruptcy. Among the investors caught unaware were many money market mutual funds that were ill equipped to deal with securities that faced a permanent markdown in value. Funds that were supposed to be risk free were shown to be anything but.

This shock was a primary reason why the global financial system essentially locked up overnight. One could argue that the financial crisis was an ongoing series of miscalculations on the part of issuers and investors. Issuers created securities, nominally rated as risk free by the ratings agencies, that came along with higher coupons. Investors were more than happy to purchase these securities in the hope of garnering additional yield.

This highly stylized view of the financial crisis of 2007–2009 just happens to confirm the proposition made earlier that a primary role of the financial markets is to coax risk-averse investors into risky securities. Sometimes bankers and their clients fool themselves into thinking that financial alchemy is possible, that somehow we can turn risky securities into risk-free ones. While diversification can mitigate some risks, it cannot eliminate them. If we learn one lesson, it is that risk is inherent in the financial markets. We can try to identify and reduce those risks through careful portfolio construction, but those risks still remain.

Nor should we ever believe that any security is truly risk free. Even Treasuries that are assumed to be risk free are not. Let's leave aside interest rate risk for the moment. While there is little risk that those securities will not be paid off in whole, there is a range of outcomes that make Treasuries risky. For foreign investors, a continued decline in the U.S. dollar would make U.S. government securities a money-losing proposition.

For domestic investors, currently much of the Treasury yield curve is trading below expected inflation. Investors are therefore likely to experience negative real, after inflation, returns. We are also leaving the issue of taxes aside at the moment. This is not an unusual situation for the past couple of years. In fact, talk of "financial repression" is rearing its head. This would be a policy of keeping interest rates low for a long time, which would make the available real return on Treasuries in any foreseeable scenario negative.

So if securities that are assumed by everyone to be risk free actually entail real risks, we should recognize that every investment entails risk. The great challenge for investors is to accurately identify these inherent risks before they come to pass. Unfortunately our minds ensure that we will get fooled from time to time. Extrapolating past returns into the future is a common mistake that investors make time and time again.

When the Walls Come Down

Investors chase market returns. Anyone who has looked at the data sees this phenomenon play out over time and across asset classes. As a market declines, investors pull their money out. As that market rises, investors put their money back in. On the whole, investors earn less than they would have had they simply stayed put. Carl Richards coins this phenomenon the "behavior gap." By one estimate, investors lose up to 1% per annum by poorly timing their buys and sells.

Research indicates that investors aren't necessarily trying to time the market; rather they are extrapolating returns several years into the future. A likely explanation for this is that risk-averse investors need to see some confirmation that it is "safe" to invest in a particular asset. The only visible sign to most investors that a market is safe is that the price has gone up. The opposite case holds when prices decline.

This goes back to our differing explanations of risk. To the investor who is solely extrapolating returns, the market that has fallen in price seems more risky because all you see is further losses down the road. However, to fundamental investors, an asset that has fallen in price, absent any additional bad news, has become cheaper and is therefore less risky. It will take at least the absence of bad news to bring investors back into the market.

In that sense, it is often said that markets climb a "wall of worry." We can best think of a wall of worry as the market's list of real, potential, and imagined risks. A stock is always in the process of pricing in those risks. As time goes on and those risks are proved to be either unfounded or less impactful than previously thought, investors become more comfortable. More comfortable investors make for a higher stock price. The opposite is true as well: if risks not foreseen come to pass, a stock will decline as investors rate it as riskier than previously thought.

At any point, there is a cornucopia of potential risks. There are your run-of-the-mill economic concerns focused on growth and inflation. Any individual company or industry faces another whole set of specific risks focused on sales growth, disruptive technological innovation, and competition. Then there are your more existential risks like global warming or terrorism. It is not hard to come up with any number of risks with wildly varying probabilities of occurrence.

Indeed, some analysts make their living by focusing on a particular risk to the exclusion of all others. This risk might be hyperinflation, or it might be deflation; whatever it is, according to these analysts it is devastating, and it is often just around the corner. These analysts usually have some preferred asset that is assumed to be a shelter from the coming storm.

We find it ridiculous when the term guru, which has its origin in religion, is applied to investing. However, in the case of those analysts who are wedded to a single overarching worldview, the term is appropriately applied. The world of investing is too complicated a place to rely on so-called gurus whose advice withstands any factual refutation.

(Continues...)

Excerpted from ABNORMAL RETURNSby TADAS VISKANTA Copyright © 2012 by Tadas Viskanta. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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