Stock markets have been relatively flat over the last three months. The biggest news maker is obviously Greece. Being crushed under a humongous debt load of 451 Billion Euros owed to its Euro-zone partners, the Greek government decided to call a referendum so its people can decide whether to pay its creditors back. Surprise! They decided not to. Surprise again! They have done it 5 times since Greece’s independence 187 odd years ago. In fact, Greece has spent approximately half of those 187 years since it achieved independence from the Ottoman Empire in a state of default and therefore denied access to international capital markets – a position it is likely to resume in the very near future.
As the old adage says: “fool me once, shame on you; fool me twice, shame on me; What about “fool me five times…”???
Members of the European Union should have studied the Latin epic poem written by Virgil 2000 odd years ago: “Timeo Danaos et dona ferentes.” In English, it would translate into: “I fear the Danaans (Greeks), even those bearing gifts.”
Markets don’t seem to care too much about whether Greece stays or leaves the Euro zone. To put the whole situation into perspective, Greece is a country of 11 million people with an economy of $283 Billion, roughly 1.6% of the European Union’s economy of $17.6 Trillion.
The bigger risk is what will ensue if Greece obtains special treatment (i.e. a restructuring of its debt to a more manageable amount) whereas Ireland and Portugal paid the full price of austerity imposed by the same institutions; being the European Central Bank (ECB), the International Monetary Fund (IMF) and the European Commission (EC).
Speaking of austerity, here’s a famous quote from Winston Churchill…..
A little historical perspective pertaining to currency unions….
Over the past two centuries, European countries have tried to justify their currency unions without avail.
Here are examples:
- 1865 – 1927: Latin Monetary Union (France, Belgium, Italy, Switzerland and Greece)
- 1870 – 1924: Scandinavian Monetary Union (Sweden, Denmark and Norway)
- 1922 – 1972: Benelux Monetary Union (Belgium, Netherlands and Luxembourg)
- 1972 – 1979: European “currency snake” (France, Germany, Netherlands, Belgium, Italy and Luxembourg)
- 1979: Creation of European Currency Unit (ECU)
- 1999 – ?: Euro
‘‘History doesn’t repeat itself, but it does rhyme!’’
As the S&P500 has climbed over 200% since the depressed levels of 2009, we think it is appropriate to address the notion of investment risk so our clients understand what we deal with continually in our duty to manage your money in a prudent way.
WHAT RISK MEANS TO US (CLARET)
Most academics and finance experts have brainwashed investors into believing volatility as risk, probably because it is quantifiable through statistical mathematics. However, the reality is that it falls way short as “the definition” of investment risk. We don’t think investors fear volatility. What they fear is the possibility of permanent loss of capital.
A downward fluctuation by definition is temporary and does not pose a problem if an investor can hold on for a recovery. A permanent loss is irreversible. We can ride out volatility but not a permanent loss.
The problem is that the possibility of permanent loss is not quantifiable. The probability of loss, just like the probability of rain, can only be estimated but not truly known.
HOW TO COPE WITH THE UNKNOWN
We don’t believe that the future can be predicted with any consistency given the infinite number of factors and randomness of the events that can influence it. Yet, investing requires us to position a portfolio for future development.
To cope with the unpredictability, we would like to emphasize the following two points:
- Although we cannot know what will happen, we can have some insights about the possible outcomes and how likely they are to occur. In other words, we must be able to find ideas that provide an asymmetrical expected return: the estimated upside potential must exceed the estimated downside risk by a good margin.
- There is a big difference between probability and outcome. Even when we know something is likely to happen, it does not mean it will happen. Unlikely things happen – and likely things fail to happen – all the time. Probability is not certainty.
THE POSSIBILITY OF PERMANENT LOSS OF CAPITAL IS NOT THE ONLY RISK
Risk can manifest itself in very different forms: credit risk, concentration risk, illiquidity risk, leverage risk, funding risk, etc. Among them, most can be controlled (but NOT eliminated) by using discipline and knowledge. However, the following two warrant mentioning since it concerns most individual investors’ behavior:
- Risk of falling short: an investor might need a certain amount of income to live on. With interest rates being this low, it is a distinct possibility an insufficient amount of income will be generated from the portfolio to cover the investors’ expenses;
- Risk of missed opportunities: an investor, after having sold his entire portfolio following the dramatic bear market of 2009, decides to stay out of the market and watch one of the biggest bull markets runs over the last six years.
THE BIG PICTURE
As investment managers, we need to differentiate risk control and risk avoidance. Whereas the former is indispensable, the latter is not an appropriate goal: avoiding risk will also bear no return.
In order to know how to take risk appropriately, we need to know some of its characteristics:
- Risk is counterintuitive:
- The riskiest moment is when everybody believes that there is no risk;
- Fear that the market is risky can render it quite safe;
- As an asset’s price declines, all else being equal, it becomes less risky;
- As an asset’s price rises, all else being equal, it becomes more risky;
- Adding a few “risky” assets does not always make a portfolio more risky. It can actually make it safer thanks to the increased diversification.
- Risk aversion makes markets safer and more sane:
- When investors are risk-conscious, asset prices tend to be more in line with reality. As the saying goes: markets always climb a wall of worries;
- When investors are euphoric and tolerate high risk investments, the possibility of loss rises. The tech bubble would be a prime example of investors having drunk all the cool-aid…
Simplistically, risk is low when risk aversion is high and high when it is low.
- Risk is often hidden and deceptive: some stocks with bad fundamentals stay high for a long time thus creating a perception of safety until a negative event occurs. Then it collapses spectacularly in a very short time. Think of Enron and Nortel.
- Risk is multi-faceted and difficult to deal with. There is no magic formula that can reduce the different forms of risk into one easy to deal with number. Sometimes, they overlap, sometimes they contradict one another.
- The task of managing risks should be dealt with constantly and not sporadically. It should be the responsibility of every participant in the investment process, applying experience, judgement and knowledge.
In conclusion, let us repeat Charlie Munger’s comment on investing in general: “it’s not supposed to be easy. Anyone who finds it easy is stupid.” It definitely applies to risk management also. Believing risk control is an easy task is perhaps most dangerous since it creates a sentiment of excess confidence that makes investors do dumb things. A good dose of humility, modesty and knowing what we don’t know would be a good start in learning how to control risk.
As the Greek saga continues and the Chinese market takes a tumble, we think risk control is more important than usual:
- Interest rates are at zero or near zero;
- Money has been flowing into riskier assets in search of higher returns;
- More and more companies are going public with funny multiples.
Warren Buffett put it best: “…the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
We would also like to let you know that the federal government has increased the contribution level for TFSAs to $10,000. Those of you who would like to maximize your contribution, please call us and we will take care of it for you. For those of you who do not have a TFSA yet, you should have one since it is the only tax gift from the government that we know of with no strings attached.
Have a good summer.
The Claret team