Extreme Outcomes (Part 2)

…and what they can do about the underestimation of acute risks

Samuel Lee 13.06.2013
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In Part 1 of this article, we set out scene on why investors underestimate acute risks. Here, we explore what they can do about it.

Lost Decades
The 2000s were an object lesson in long-wave risk. Many investors are now under the impression that they've lived through a bear market, surely the worst of their lifetimes. While the tech bust and the financial crisis were extraordinary, aggressive central bank easing and massive government deficit spending ensured that the extraordinary circumstances didn't produce an extraordinary decade of returns or volatility. In Exhibit 1, I've produced the cumulated returns of a simple 60/40 S&P 500/intermediate government bond portfolio, rebalanced at year-end. The numbers are adjusted for inflation, and the chart's Y-axis is on the logarithmic scale, meaning each uptick represents a 10-fold increase. By these lights, the past decade looks unremarkable. You only had to go back to the 1970s to find worse drawdowns and longer periods of underperformance.

The most striking thing about this graph is how clumpy returns are over decade-long spans. The 1950s, 1980s, and 1990s account for almost all of the portfolio's post-World War II returns. Imagine if you retired during the 1960s or 1970s: Your portfolio would have gone nowhere, with tremendous volatility. By the late 1970s, valuations for both stocks and bonds were at generational lows. It was a tremendous transfer of real wealth from retirees, who were drawing down their assets, to savers, who went on to enjoy outsized returns for the next two decades.


Lost decades (and ruined retirements) are not unusual events. Out of the past eight decades, starting with 1931, three (the 1930s, 1970s, and 2000s) showed returns of less than 1% annualized after inflation. Counting taxes and management fees, those returns would have been reduced to zero or worse. A three-in-eight chance of experiencing a lost decade doesn't sound too great.

Severing the Left Tail
Frankly, most of us will not do a great job timing the huge shifts. A good strategic portfolio for the typical investor should presume that the future is largely unknowable and that various types of disaster will eventually occur, whether it's boom or bust, inflation or deflation. In other words, I believe investors should consider owning a risk-parity portfolio. The key to understanding risk parity is to realize that two great economic forces determine most of an asset class' behavior: economic growth and inflation. These produce four possible economic scenarios:

·         Rising inflation
·         Falling inflation
·         Rising growth
·         Falling growth

More precisely, only the unexpected changes matter. If the market expects inflation to be 10% next quarter, and inflation turns out to be 10%, asset prices will not budge because expected inflation is already factored into the price. Conventional portfolios performed poorly during the financial crisis because they were overly reliant on rising economic growth and rising inflation. The diversifier of choice back then was commodities. Unfortunately, 2008 was a perfect storm of falling inflation and falling economic growth. The only asset class that could hedge against such a scenario was nominal Treasury bonds.

Asset classes react differently to each economic scenario. It rarely matters what kind of equities you hold--small or large cap, growth or value, quality or junk--if economic growth turns out to be lower than expected, equity prices will fall. I'm not claiming equity styles don't offer diversification. Over long periods of time, different styles can produce very different returns, especially when starting valuations are very different. However, over a lifetime, your exposures to different macroeconomic environments will affect your outcomes the most.

A controversial method I advocate is to obey trend-following signals. Such strategies are procyclical, cutting exposure to an asset when its price falls below its moving average, usually measured over 200 days, and adding exposure when an asset's price rises above its moving average. At first glance, there's no fundamental reason why it should work. Both dyed-in-the-wool value investors, a hugely successful group, and many academics dismiss it as voodoo. However, during the past couple of decades, academics have chipped away at the efficient-markets dogma, and many acknowledge that markets do display cycles of self-perpetuating fear and greed. (Tobias Moskowitz, Yao Hua Ooi, and Lasse H. Pedersen wrote the most influential study on this subject.)

Trend-following strategies have produced excess risk-adjusted returns in virtually every market studied over long periods. There are a couple of theories as to why they work. The first is behavioral. Investors are herd animals, stampeding in and out of markets at the same time because of irrational behavioral biases. The second is fundamental. Central banks often manage interest rates and exchange rates to achieve macroeconomic stability. Their interventions are often countercyclical, preventing prices from fully reflecting the market's opinion of fair value.

Exploiting trends requires paying higher transaction fees, incurring more taxable gains, and suffering from occasionally eye-popping tracking error to conventional benchmarks. Despite these costs, trend-following provides cheap insurance against a lost-decade scenario.

The markets will at some point suffer a prolonged bear market for any number of reasons. The average investor is certain to lose a lot of money at some point in the future. It's best to acknowledge this fact and avoid betting too heavily on any one outcome. The implications are unsettling, but not nearly as much as losing everything. Bad things happen.


Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor.

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Samuel Lee  Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor

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