Seeking bigger market returns? Accept the higher risk
You may have reasonable expectations of what you can expect from your investments during the coming years and decades. But regardless of what your riskadjusted return expectations are, the first rule of economics cannot be denied: There is no free lunch.
I was reminded of this by a report that the League of California Cities wanted the state’s big public pension fund, Cal PERS, to boost investment returns. However, I did a double-take when I read the following:
“The legislative representative to the League of California Cities urged the Cal PERS Investment Committee Monday to think ‘out of the box’ in finding a way to exceed its 7% investment return projections, saying that cities won’t be able to pay their monthly contributions to the pension plan if returns are that low.”
There is so much wrong with this statement, so much at odds with the body of knowledge investors have painfully amassed over decades, that my first reaction was that I must have misunderstood it.
Let’s take a deeper look at the error here and why the underlying thinking it reflects is one of the most dangerous attitudes any investor can have.
First, potential returns for any investor (institutional or otherwise) encompass a broad range of possible outcomes. We know what different asset classes have returned historically; this provides the baseline for what is probable, perhaps even likely. But there is always the possible outlier that surpasses the historical return ranges. While these are improbable, they are not impossible.
Second, future returns are directly correlated with how much risk an investor is willing to assume. Risk can be defined as the probability that actual returns on an investment will be lower than the expected returns. Take on more risk and you might generate more returns than the market — or, as so often occurs, produce less - than market returns or even losses.
Those who declare that they want higher returns must recognize that they are also implying a willingness to risk lower returns to get them. That is the very definition of risk. Pursuing alpha, or above-market returns, means you will occasionally forsake beta and matching the market. Any other way would mean a free lunch.
Next, there is execution risk. There is no guarantee your investment managers will adequately express the risk-reward ratio you want in pursuit of your goals. Note that this is the single biggest area that consultants and advocates should focus on; it is the one thing that is most within the control — and dependent upon the skill — of the money managers.
Finally, returns are driven by factors such as interest rates, corporate profits, inflation and valuations, to name but a few. Knowing this, investors must make probabilistic decisions using incomplete information about an unknowable future. But of all the things returns are based upon, they are never dependent upon what you need or desire. Those issues are irrelevant.
History teaches us that acting on the emotional desire for a specific level of return very often leads to bad investor behavior — and losses. Worse yet, there will always be some broker or consultant willing to sell you an outside-the-box product to satisfy your desires.
Mr. Market doesn’t care what your funding needs are. The market is oblivious to how much or how little you have chosen to fund your future liabilities and obligations. It reflects the collective hopes, wishes and dreams of all the participants in risk assets. And the market always stands ready to punish those who foolishly refuse to abide by rules that apply to everyone.
America is hurtling headlong toward a public pension-fund crisis, caused by the habitual underfunding of retirement plans by state and local governments. The folks who believe they can simply demand higher returns to make up for those shortfalls are only going to make it much worse.