Let’s talk risk versus return

Investors have for the most part been spoiled by the strong returns generated over the past few years from the broader equity markets, especially by U.S. stocks that have posted double-digit annual gains since the bottom of the financial crisis.

But we fear it has fundamentally changed investors’ understanding of the relationship between risk and return, something all too evident by the dumbfounded reaction to the market correction early last week.

Consequently, it isn’t surprising to see investors herd into what were once considered to be the riskiest asset classes — equities and real estate — finding safety in their almost perpetual linear ascent to new highs.

Consider this: According to Bloomberg Business, the average Wall Street trader is 30 years old and has never seen a rate hike or a sizable market correction.

Compounding matters is that higher returns are no longer associated with higher rates of inflation. For example, interest rates have a remained near zero for seven years now and yet market participants have sent commodity prices to 13- year lows, indicating we are in a deflationary environment.

This makes it very difficult to determine a realistic longterm return objective, since it is human nature to increase one’s willingness to take on risk when markets are setting new highs, and vice versa when they are setting new lows.

Funds flow data show how investors pile into funds with the highest recent returns while selling those markets or sectors that have recently been underperforming.

This behaviour creates a major headache for most investment managers given that they have to outperform a particular benchmark, such as an equity market index, or face redemptions. As a result, they can be highly incentivized at times to take on excessive risk to try to play catch-up.

On the other hand, some managers target a rate of return either in nominal or real (inflation adjusted) terms that is separate from the market and/or what others are doing.

The benefit of setting an independent return is that it allows the manager and/or investor to also focus on mitigating the level of risk a portfolio is taking on at the same time — essentially removing the dangers of return chasing.

Sizable corrections such as the one on Aug. 24 also provide a great chance to check in with your investment manager and determine the level of risk being taken in your portfolio.

Simply ask for your portfolio’s standard deviation and return profile during the past few months and compare it to a simple passive index, especially if you are undertaking an alpha strategy or paying the manager to outperform the market.

For example, a typical portfolio with a 70-per-cent long equity position would normally correct seven per cent or more in a 10-per-cent broader market correction, assuming the manager is no better or worse than the index and that bonds stay flat.

One would expect a much lower downside for absolute return managers, so this is also a great time to double check and confirm if any riskmanagement strategies are being deployed and actually working as promised.

The average Wall Street trader is 30 ... and has never seen a rate hike

(or correction)