Direction Alerts Sunday Edition

  Do You Really Know What Risk Is & Can You Handle It? Today I wanted to share with you a great article that Sven Carlin, weekday contributor to our free [Investiv Daily]( newsletter, wrote recently about every investor’s least favorite subject: Risk. Here’s a reality check: all investments, whether you want to think about it or not, carry some degree of risk. Whether its the risk of market conditions souring, or political risk, or the risk that comes with having all of your eggs in one basket (stock).  Knowing what level of risk you’re comfortable with, and knowing what risks your portfolio is exposed to, can mean the difference between sleeping at night and feeling like you’re on a perpetual rollercoaster. You can’t eliminate risk from your investments. But by understanding risk beyond a textbook definition, thinking about risk in real-world examples, and by asking yourself what you’re ultimately comfortable with, you can create a portfolio allocation that allows you to sleep at night even if the sky is falling. Sven’s article Do You Really Know What Risk Is & Can You Handle It? tackles risk head-on. Here’s Sven:   - Risk can’t be defined as volatility as it includes factors like your retirement, your children’s college tuitions, mortgage payments, unemployment, etc. - In life altering situations, nobody thinks about the highest expected utility hypothesis. - The personal side of risk is more important than any ratio, coefficient, or return potential. Introduction Defining investing risk is crucial for a healthy approach to investing. Some say risk is the chance that something goes wrong, some define it as volatility, others as the risk of permanent loss. However, 99.9% of the articles, news reports, and videos, don’t even mention risk, let alone define it or quantify it for the discussed investment. This is because 99.9% of people don’t like to face reality. It’s human nature to put our heads in the sand and postpone difficult decisions. To be a great investor, you have to look at reality and then make it work for you. This involves a clear understanding of the following three concepts: defining risk, knowing how much pain you can tolerate, and having a straightforward plan of action in case things change. In today’s article, I’ll discuss these three concepts as they are the essentials of investing and should come before anything else. Defining Risk – What Is Risk For You? The first pre-condition every investor should have is a clear understanding of what risk is. Risk is usually defined as volatility with the notion that the higher the risk, the higher the returns. This is complete bullshit. Pardon my language, but I really need to make a strong point here. My heart beat is volatile but not risky, it becomes very risk when the volatility stops. The same holds for the stock market. Risk got detached from what it really is when Markowitz published his paper on modern portfolio theory in 1952 assuming that return variance is undesirable based on the expected utility hypothesis. This diverged from the psychological approach to risk set by Frank Knight in 1927 where risk was subdivided on quantitative, operational, mathematical, or statistical and psychological, or personal segments. Estimating risk through variance, variability, or volatility partly touches on the quantitative side of risk, but completely disregards the most important side of risk, the personal side. On the quantitative side, estimating risk through variance omits various factors and therefore gives a wrong description of what risk really is. Those omitted factors are: Stock risk is detached form business performance and business returns. The first fallacy of using variance as a measure of risk is that risk is completely detached from the underlying business’s fundamentals. To make life easier, market participants have accepted the notion that markets are efficient where all available information is immediately priced in. If markets are efficient, you don’t have to think about risk, just let the market tell you what the risk is. The higher the stability, the lower the risk, i.e. when stock prices are high and real returns low, the risk is considered to be low, while when real future returns are high, the risk is considered to be high. The S&P 500 has been relatively stable in the last 8 years, so the majority considers it a well-diversified low risk investment.  I have written here how even [Goldman Sachs]( recommends the S&P 500 as the best investment vehicle. However, when a crash comes for whatever reason, the S&P 500 suddenly will become an extremely risky asset as the swings will be extreme. The S&P 500 reached a low of 775 points in October 2002 and a low of 672 points in March 2009, not because stocks were expensive, but because market participants were afraid stocks could go even lower. From a value/business perspective, the S&P 500 was at its lowest risk point on March 9, 2009. Risk estimation doesn’t take into account the potential influence of new information. The easiest way to estimate risk is by taking macroeconomic and other facts as fixed. However, this approach is flawed because we can’t know whether inflation will reach 5% by 2018 or if there will be a recession in 2019. A standard approach to risk based on historical volatility doesn’t even consider such developments. However, it’s extremely important to know what would happen to stocks in such a scenario and what you would do. Before digging deeper into what would you do, let me describe the third fallacy related to the standard perception of risk, risk and time. Risk estimation doesn’t take into account time. Let’s say two investments are equally priced at $100. What investment would you prefer? The one that is extremely volatile but at $500 after 10 years, or the stable one that will be at $150 after 10 years. The standard approach to risk doesn’t include time in the equation. To be honest, I’m extremely happy about that because it allows me to reach extremely high returns as I buy extremely undervalued, highly volatile stocks around the globe. The essence of financial markets is dynamic, however, risk is always approached from a static perspective, be it historical, based on past information, or just for one future time frame. Now, when you think about risk, do you think about volatility—i.e. immediately shunning investments like emerging markets or commodities—or do you think long term, i.e. not caring much about fundamentals because in the long-term, stocks are always a great investment? Whatever your quantitative approach to risk is, there is the personal side that is even more important because the majority of investors don’t look at their investments by plotting variance on their expected utility hypothesis. If the majority doesn’t do it, Markowitz’s model simply doesn’t work, no matter how perfect it might appear mathematically. Let me introduce to you the part of risk that got lost after 1952, the personal part. What Would You Do If The Market Dropped 25% In Four Months? What a mathematical model can’t grasp is the age you want to retire at, the amount of money you need to pay off your mortgage, the cost of your children’s university, or the fact that you might lose your job if there is an economic slowdown. Any changes in the likelihood of reaching the investment target related to the above goals immediately changes the perception of risk a person has, no matter the expected utility coming from the investment. The easiest approach to including the personal perspective on risk is to answer the question, what would you do if a bear market starts tomorrow and stocks drop 25% in the next four months? Most investors would say that they would hold as stocks will perform well in the long term. But let’s say now the market drops another 25% and suddenly your retirement is postponed by 7 years, your children’s college funds are at 50% of what they were, and there is a high chance you might get fired in the next six months. Would your perception of risk change in such an environment and are you prepared for such a scenario? Perhaps you are, and I congratulate you for it, but 99% of market participants aren’t ready for such a scenario just as they weren’t ready in 2000 or in 2008. Investors aren’t prepared to such events because most don’t want to face reality and the risks related to it. If facing reality were normal, the S&P 500 would never have reached these levels, wouldn’t be this volatile in the long term as shown in figure 2, investing would be extremely boring, and, at last, efficient, exactly as Markowitz described it in 1952. Well, he didn’t get the Nobel prize for nothing. Conclusion Nobody can know where the market will be at the end of this year, but what everybody can do is create a clear plan of action or, even better, inaction to whatever the market brings. I’ll conclude with my personal worst case scenario and what I would do if the market dropped 50% by the end of 2017. I’m prepared to watch my portfolio drop even more than 50% in case the S&P 500 drops 50% as I am very exposed to emerging markets. History tells me that emerging market assets are far more volatile and any kind of panic leads to forced sales no matter how undervalued the assets are. History also shows that this reaction is temporary and the rebound usually leads to even higher levels. Therefore, I’m prepared to lose more than 50% in a given year, however, I know that I’m exposed to returns of at least 50% per year if things continue to be good. I also know that such market cycles usually happen every 8 years. For me to lose money in the long term, such cycles should happen almost every two years. I can accept such a volatile investment strategy because my life requirements aren’t at all dependent on the stock market. Be sure to know what you would do if things suddenly change and whether you can sleep well with the portfolio allocation you are exposed to at the moment. Imagine what all could go wrong and think about what your life would look like. If you don’t like it, make the necessary changes even if your returns might be a few percentage points lower than what the S&P 500 does in 2017 if it remains a bull market. If a bear market comes along and you rebalanced in time, you will be a very happy person.  Some of the questions Sven asked in this article are difficult to think about, but facing reality when it comes to risk and your investments will help you stomach the next 2000 or 2008. Sven is a PhD and hedge fund manager, and he puts out better content for free than you’ll find anywhere else. If you haven’t already, [click here]( to add your email address to the list to get Sven’s articles delivered to your inbox every day. Trade Smart, Kristina Keene Brought to you by Investiv                                --------------------------------------------------------------- If you are having trouble reading this email, you may [view the online version]( This email was sent to {EMAIL} by Investiv, LLC 3400 North Ashton Blvd. | Suite 170 | Lehi | UT | 84043 [Forward to a friend]( | [Unsubscribe]( Disclaimers Investing is Inherently Risky There are risks inherent in all investments, which may make such investments unsuitable for certain persons. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities. You may lose all of your money trading and investing. Do NOT enter any trade without fully understanding the worst-case scenarios of that trade. And do NOT trade with money you cannot afford to lose. Past performance of an investment is not necessarily indicative of its future results. 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