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Learning To Expect The Unexpected

Just when we thought we knew how risky financial markets could be, the past year’s roller coaster ride reminds us that what lies ahead can be scarier than what came before.

Although some variant of the disclaimer “past performance is not indicative of future results” is slapped onto nearly every financial prospectus, professionals continue to view history as the best way to measure future risks. Modern portfolio theory is built on the assumption that an investment’s expected return will be normally distributed on a bell curve around an average expected return. Recent market results, however, reinforce the shortcomings of this methodology. Human judgment is needed in developing investment strategies so factors that cannot be quantified can still be considered.

Experts have an alphabet soup of risk measures: Alpha, Beta, R-Squared, Variance and Standard Deviation, to name some of the most well-known (see accompanying glossary). But, regardless of the measures, analyzing historical data to predict investment risk employs the delusion that if something has not happened in the past, it will not happen in the future.

Dealing With Black Swans

Sometimes something unprecedented happens. Maybe it is a positive development, such as the United States emerging economically unscathed from World War II. Maybe it is negative, such as a nationwide collapse of housing prices. Looking ahead, downside risks might include a terrorist attack with weapons of mass destruction, an inability to borrow in U.S. dollars that leads the Treasury to default, or other even more unimaginable scenarios.

In the more sophisticated of modern analyses, forecasters manipulate the historical data to illustrate their view of the future. However, this exercise can only encompass variables that come into the practitioner’s mind. Typically, these include traditional measures such as inflation, employment levels and future growth rates.

Often, financial professionals provide clients with a range of possible results to help shape their expectations, but this range generally does not include the most extreme of possibilities, and so, even when rare events are included in financial simulations, these predictions based on the unpredictable may not be reported to clients.

In 2007, Nassim Nicholas Taleb brought the phrase “Black Swan” into popular usage to describe an occurrence that is extraordinarily rare, yet has an extreme impact and, in retrospect, seems easily predictable. His book, The Black Swan: The Impact of the Highly Improbable, takes the radical view that, in sum, a few such events are what truly matter; the range of possible expected returns generally given to investors is effectively meaningless in predicting actual returns. While planning in such a model would be not only impractical but also impossible, investors must learn to recognize that a hundred-year flood can occur more than once in a hundred years.

Diversification is typically the only true safeguard in the personal finance industry. By adding investments to your portfolio that are likely to react differently from your previous investments in response to market changes, you can lower the overall expected risk of your portfolio without lowering its expected return. However, even a portfolio that seems diverse can be vulnerable if its contents, though varied, rise and fall in response to the same triggers. Recent events have brought out all sorts of hidden correlations, causing even apparently diverse portfolios to fall in synchrony. Equity portfolios, for example, have suffered over the past two years as a correlation has emerged between hard assets, such as real estate and natural resources, and global equities.

Coming To Terms With Risk

Risk is an investor’s best friend, since it is the principal driver of returns. Because investors seek to protect their assets, they demand higher returns for higher risk investments. The possibility of loss lies along the path to greater rewards.

When projecting future returns, it is imprudent to expect the expected. Considering that the average annual return of Standard & Poor’s 500 stocks between 1926 and 2008 was 11.7 percent, investors might expect that in a normal year, returns would be between 9 percent and 14 percent. Surprisingly, this only occurred in six out of the 83 years.

Investors should recognize that any expected return is an ever-changing approximation. Robert Stambaugh, a finance professor at the University of Pennsylvania’s Wharton School, concludes that since expected returns constantly change as new data are added to the existing set, the true variability of returns may be greater than previously understood. This translates to higher upside and higher downside potential.

The use of the word ‘risk’ emphasizes the dangers of unpredictability. However, unexpected events leading to upside ‘risks’ are just as possible. Diversification ensures that a portfolio has the ability to capture this upside potential as well. Investors should seek to structure their portfolios to avoid the impact of highly unanticipated rare negative events, while still being able to capitalize on the surprisingly positive ones.

The True Risks

Alongside these unpredictable and rare risks and benefits, there is another risk that is often highly predictable: investor behavior. At Palisades Hudson, we believe in long-term investing, which dampens the effects of volatile swings in the short-term. Too often, however, investors respond to short-term market changes with short-term thinking; they sell equities at depressed prices only to miss the future rebound. While it is impossible to base investing strategies on Black Swan type risks, it is possible to take into consideration the risk of investor behavior.

Investors should set specific financial goals for themselves, such as, “I want to retire with $2 million in my portfolio ten years from now.” Then, they can compute how much risk they would have to take on in order to reach that goal. The more risk an investor is willing to tolerate, the more ambitious his goals can be, since higher-risk investments, when all else is equal, yield higher returns.

For an investor who is unwilling to tolerate very much risk, however, it is wiser to revise the goals and choose lower risk investments, instead of later letting emotion take over and selling out of fear during a temporary downturn.

Risks in the equity market are everywhere and are often unseen until it is too late. In such an uncertain world, more and more investors are hiding from risk and looking for safe investments. With the Federal Reserve’s low interest rate policy and the government’s burgeoning debt, higher inflation seems inevitable. Changing to an ultra-low-risk portfolio may avoid the current market risk, but it also consigns an investor to losing wealth in real-dollar terms and increases the risk of falling short of long-term goals.

Despite its limitations, relying on extensive historical trends over long periods remains the best way to foresee what the future may hold. While precise returns are impossible to predict, the relative return potential at different levels of risk is fairly consistent. Jeremy Siegel, another Wharton finance professor, concludes that over the last 200 years, the compound annual premium on stocks over bonds is about 3 percent a year. This marginal return equates to an additional $800,000 earned over 20 years of investing $1 million in stocks rather than bonds. For an investor who is capable of tolerating risk, then, the best policy is to accept riskier investments and adopt a long-term mindset in order to get through difficulties in the short-term.