Risk is often a misunderstood concept. We all think we get it, and then when it strikes, we are usually caught by surprise.
Don’t believe me? Consider home fires for example. According to the National Fire Protection Association, there were an average of 366,600 home fires per year during the 2007 – 2011 period in the US. Given there are about 132M dwellings in the country, this implies that home fires occur at a rate of about 0.3% per year, or a 3% chance over a 10 year period for any given home.
Now 3%, even though small, isn’t exactly irrelevant. This is especially true given that home fires often result in deaths, a far worse scenario than a 20% drawdown on your investments! Yet, how often do you test your smoke alarm? Do you enjoy being alive? The alarms do say to test weekly, don’t they?
Sorry Folks, Risk Happens
We somehow tend to believe it happens only to others. Perhaps we are biologically wired to think that way. Maybe that’s why we jump out of planes in parachutes or do bungee jumping, or drive on a wet curvy road at 100mph. We need to remember that the “others” are actually often ourselves, our own person.
Let’s have a look at risk for three investment vehicles: the gold ETF (GLD), a popular real estate ETF (ICF), and a leveraged European fund (RYEUX). First, the good times.
If today is January 2007, you must be thinking ICF is an awesome investment. All its numbers look good. It has a very compelling Sharpe ratio at 1.83, the smallest drawdown at 12.3%, a too-good-to-be-true CAGR of 29.5% and the lowest volatility of all three instruments with a 16% annualized standard deviation. This seriously beats double chocolate raspberry cake for dessert! What else can you ask for?
Meanwhile, gold (GLD) looks like the riskiest investment of the three with the highest standard deviation, worst drawdown and worst Sharpe ratio. It’s also down from its peak earlier in May 2006.
Now, let’s fast forward a couple of years.
Of course, this includes the financial crisis and ICF, being a real estate ETF, was exactly at the epicenter of the earthquake. So it’s not surprising that it had a drawdown of nearly 80% while its volatility skyrocketed to a whopping 44.3% standard deviation. Meanwhile RYEUX, a leveraged stock fund, lost almost as much with a drawdown of 73%. Only gold had a more reasonable drawdown at 32% while managing to maintain a very healthy CAGR during the period at 15%.
Are Performance Figures Irrelevant?
In this case, all four performance figures appeared to have been irrelevant in assessing the true risk of these instruments. Ironically, GLD had the worst performance and the highest risk as measured by drawdown and volatility in 2007. Yet, it greatly outperformed the other instruments during the financial crisis. Should we then conclude that these performance measures are, to put it politely, irrelevant academic BS?
Well, not so fast.
Performance figures measure one particular aspect of risk in a narrow sense. Yet risk has many faces, and it hides in a lot of different ways. There are just as many ways to lose money as there are ways to hurt yourself.
Just because you could get hit by a bus crossing a street doesn’t mean you never cross streets. But when you do cross a street, you hopefully look beyond the obvious. You look right and left, see if the crossing light is on and you watch every moving vehicles in your vicinity. If all appear safe, then (and only then) you start crossing the street. And although most of the time the street is a dangerous place for pedestrians, it is relatively safe for you at that precise moment in time.
The ICF real estate ETF is usually a very decent investment. But in 2008, it was a disaster. The performance numbers are backwards-looking by definition, so they can’t tell you the storm is coming. One way you could have predicted the risks a priori would have been by understanding the banking industry’s ultra loose lending practices at the time, and how they repackaged low quality mortgage securities into obscure financial instruments like CDOs and swaps. And then, you would have had to assess how such practices impacted real estate prices and the economy as a whole. This is not a small feat by any measure.
An Open Mind Towards Risk
For this reason, I believe it’s important to keep an open mind towards risk. Numbers do tell part of the story and can be helpful, but they are not good enough. Having some understanding of the economic situation, and especially the drivers of growth and risks can be very enlightening.
I won’t claim to have been up to speed on CDOs and swaps in 2007, but I recall seeing home prices skyrocketing and Ads on TV about buying a house with no money down. I remember when you could borrow 125% of the value of your home with no cash down! To me, such observations were hints that thing were getting a bit out of control. As a result, I made a point of not investing in REITs nor any real estate funds, despite their awesome CAGR and low volatility leading up to that point. It turns out this was a good decision.
One simple way to manage the unknown risks is to diversify across asset classes at all times, as this is the ultimate insurance against a misstep. It’s always possible to be wrong in your analysis, to make a mistake, or to forget a key piece of information. But by being properly diversified across asset classes at all times, you make sure that you won’t get hurt too badly when disaster eventually strikes. In my humble opinion, any portfolio, whether actively or passively managed, should always be well diversified across asset classes at all times for that very reason.