(Publisher’s Note: This article originally posted on 5/10/22)
2022 seems like a risky year.
There’s a lot going on: A global pandemic. Rising inflation. Rising interest rates. War in Eastern Europe.
Yet many investors still struggle to come to terms with the concept of risk, said Daniel Crosby recently on his Standard Deviations podcast from Orion Advisor Solutions.
“I work in behavioral finance and I think it’s useful to get away from the academic definition of risk and give one that is more usable,” Crosby said to his guest, Rick Bookstaber, founder of Fabric RQ.
One problem is that there are many different definitions of risk, and people are often misaligned when they have conversations about risk, said Bookstaber, a risk specialist who has had chief risk officer roles at Morgan Stanley, Salomon, Bridgewater, and the University of California pension.
Financial advisors are often taught about risk in an academic or institutional sense, but for the individual, risk is usually defined around a timeframe in which risk actually matters for them.
“The typical risk we hear discussed is looking at the bouncing up and down of the market day-to-day and what might happen next week, but for individuals, risk is really the risk that they will not be able to obtain their goals,” said Bookstaber. “The risk is longer in terms of timeframe, but it is also multifaceted.”
One goal most people have is to achieve security and avoid despondency – or not to be turned out on the street due to poverty, said Bookstaber. This is a much more complex concept of risk than merely worrying about whether the market or the value of their portfolio goes up or down—it’s the portfolio in the context of their lifestyle, lifespan, goals and risk aversion.
But different individuals have different concepts of risk. Traders are worried about what’s going on in markets intraday or day-to-day. Hedge-fund and portfolio managers are thinking in terms of months, quarters and years. And people are often just thinking about returns at a specific point of time.
“The issue is that people in academia don’t really look at risk for individuals,” said Bookstaber. “For individuals, it’s risk versus a goal, and that’s a function of where you are in your lifecycle.”
Older investors don’t have the luxury of waiting around for the market to recover after a drawdown that younger investors enjoy.
One problem is that people take spot measurements of their portfolio performance without keeping in mind the time horizon of their investments.
“People are not overly rational in thinking about what’s going on in their portfolio and understanding their goals,” said Bookstaber. “So if you’re an individual and you see a 2000 or 2008 kind of year occur, you’re going to be panicked and you might take action because you feel like the world is going to end and you can’t really take a long-term perspective. That, I think, is a good reason for people to have a financial advisor who can have a little more of an objective view of what’s going on.”
Perception of Risk
Not only can we not agree on a definition of risk, but risks are warped by our perspective.
For example, we tend to overweight the impact geopolitical risks, said Bookstaber, while we underweight the potential impacts of long-term trends.
“One thing I can say is that geopolitical risks tend not to actually be a big deal for the markets,” he said. “They’re not sustained in terms of the effect they have on the markets.”
Financially speaking, people should not be feeling at risk because of Russia’s invasion of the Ukraine. Bookstaber says that in modern warfare, production usually doesn’t stop—it may be briefly interrupted or disrupted, but typically combatants in modern warfare don’t lay waste to entire countries.
Thus, it’s highly unlikely that war in any one country will economically cripple the world.
Instead, they should be more concerned about overconcentration in the U.S. equity market and runaway valuations, said Bookstaber. The S&P 500 has become heavily concentrated in a small set of large-capitalization technology companies, and ownership of those tocks is often highly leveraged.
“If you look back to 2000, which is a pretty good analogue for what’s going on right now, the market dropped around 45%, but what’s called the 10-T stocks, which were a group of technology, media and telecommunications stocks, dropped over 70%. I’m not saying that’s what would happen this time but it shows that those sorts of things can occur.”
Inflation is another risk with a slow-burn impact, though it has certainly caused its share of shocks so far in 2022.
While inflation doesn’t typically make equity markets drop, it can be the starting point for recession, said Bookstaber.
“If it is secular inflation it can lead to interest rates rising from one year to the next to the next, and the rise in rates can have an effect on people’s portfolios that they may not fully realize,” he said. “You know we think of bonds as not being risky, but a 10-year Treasury bond can drop 10%, 20%, 40%, so I would say the biggest risk from a violent, short-term nature is in the overleveraged, highly concentrated world that’s focused in technology, and the longer-term risk is from inflation.”
Other Serious Concerns
But there are two more trends that stretch over even longer periods of time that may have an even more deleterious impact on investment portfolios. The first is climate change, which has moved forward steadily but slowly for decades—so incrementally that policymakers have been slow to adjust.
The second slow-building, long-term trend is demographic.
“We now what the workforce will look like in the U.S., Japan, China and Germany 20 to 30 years from now, but the implications are not very obvious,” said Bookstaber. They matter if you’re looking at retirement in 30 years, though. The nice thing about these risks that really, really matter, though, is that they’re not subtle and they’re not hidden.
