Financial Markets

Deep Risk

“It’s not the snake you see that bites you.”
-Jeff Saut, Raymond James Chief Investment Strategist

If it seems like the market has been an awfully smooth ride lately, it’s because it has.  Through August, the S&P 500 index has posted positive returns every single month this year.  My co-worker, Andrew Krieger, likes to joke I have not seen a bad market my entire career (his first day in the industry was September 10, 2001), and I tell him that before January 15, 2009, Captain Sullenberger had gone 30+ years without dual engine failure above Manhattan, but once it happened he was the calmest person on the plane.

A post on Pensionpartners.com at the end of June showed that 10 of the lowest 20 closing days ever for the Volatility Index have occurred in 2017 (the sample period is 1990 – 06/2017).  It’s irresponsible to believe this will continue indefinitely.

Now would be a good time to start envisioning how you will react will the risk shows up.  Will you be calm and level-headed like Captain Sullenberger, or will you panic like Bill Buckner in Game 6 of the 1986 World Series?  A good advisor is like a captain on a plane.  The end goal is to get everyone to their destination safely.  There will be turbulence and people getting sick to their stomachs along the way, but we invest the same reason we fly, to hopefully get to our destination faster.

Financial author, William Bernstein, describes two different types of risks that investors face.  One he labels as “shallow risk” which is a loss of real capital that recovers relatively quickly (within several years).  The other is referred to as “deep risk”, which is a permanent loss of real capital.  Deep risk is much more catastrophic for investors, but many of them tend to focus primarily on shallow risk.  Let’s look at some examples of shallow versus deep risk.

Recently, the topic of North Korea continues to come up as a worry for investors.  It is unpredictable to know how this situation will play out, and the impact it will have on financial markets.  Modifying your portfolio in preparation for or reaction to any event such as this one could end up being a big mistake.

Portfolios should be managed to avoid deep risks, not shallow ones.  It may seem as if I am making light of this situation, so we should look at some history.

The United States has been involved in conflict with other nations nearly my entire life.  With the recent 16 year anniversary of 09/11 I decided to take a look back and see how markets reacted to one of the most tragic days in history.  Here are the returns from 09/11/2001 – 12/31/2001 for three major indexes:

S&P 500 Total Return (U.S stocks):  5.54%
MSCI EAFE  (Foreign stocks):  6.39%
Barclay’s Agg Bond Total Return (Bonds):  1.20%

That may surprise most people considering the S&P 500 declined 4.65% during the remainder of September after the attack.  Terrorist attacks and wars have shown to be shallow risks for U.S. investors in many cases.

North Korea is the like Copperhead snake that slithered in front of you on the bike trail and sent you back the other direction.  The deep risks are often the snakes we do not see.

Inflation is like the snake you bought as a pet, and ignored the fact that it may eat your cat someday.  Many people pay no mind to inflation risk, but when it shows up over extended period of times it is the definition of deep risk in the purest form.  We know inflation risk exists, but it is hardly noticeable day to day (unless you lived in Zimbabwe).

Right now, not many are expecting high inflation in the future because it has been rather tepid this century (only 2.14% annually through the end of 2016 according to the Bureau of Labor Statistics).  From 01/01/1977 – 12/31/1981 inflation averaged 10.06% annually, and at the time it was hard to imagine we would see 2% inflation again.  We are humans and we suffer from recency bias.

Let’s suppose inflation shocks everyone and is 5% over the next 10 years, and at the same time your fixed income portfolio only earns 2%.  That is annualized loss of 2.86% ((1.02/1.05)-1).

If you had a $100,000 in purchasing power at the beginning of the hypothetical inflation period, at the end of it you have $74,835.68.  That is a permanent loss of real capital.  In other words, you wake up one day to notice your pet snake has gained 15 pounds and Whiskers is missing.  In the back of your mind you knew there was risk, but you chose to ignore it.

Shallow risks are hard to avoid, unless you want to attempt timing the market.  A better strategy may be to focus on deep risks, which can be planned for and hopefully mitigated.

 

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Mark Meredith and not necessarily those of RJFS or Raymond James. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. MSCI EAFE (Europe, Australasia, and Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States & Canada. The EAFE consists of the country indices of 22 developed nations. Barclays Capital Aggregate Index measures changes in the fixedrate debt issues rated investment grade or higher by Moody’s Investors Service, Standard & Poor’s, or Fitch Investors Service, in that order. The Aggregate Index is comprised of the Government/Corporate, the Mortgage-Backed Securities and the Asset- Backed Securities indices. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Inclusion of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.