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Risk Returns

John Lim  |  March 4, 2020

WE HAVE MUCH to learn about the coronavirus, but we already know a great deal about financial risk—and, indeed, recent weeks have offered a brutal refresher course. What insights can we draw from investors’ reaction to this awful epidemic? Here are eight timeless lessons:

1. The greatest risks are those we never see coming.

Some risks are predictable, such as stock market volatility. Others are less probable but widely known, like the possibility of a recession. But the most dangerous risks are those that catch us totally off guard.

This is what led to Harry Houdini’s demise. Reclining on a couch, he was unprepared for a sudden barrage of gut punches. It wasn’t just the punches that led to his burst appendix, but rather those blows coupled with the fact that he was blindsided. Similarly, the risks that have the greatest impact on financial markets are those no one expected, so we’re unprepared for them, both financially and psychologically. Think about Pearl Harbor, 9/11 and the current coronavirus epidemic.

2. Uncertainty amplifies risk.

While everyone is now aware of the coronavirus, its impact—both on human lives and on the global economy—is still a huge question mark. When a risk is quantifiable, it can be properly discounted by markets. But what do we do when there’s so much uncertainty?

A rational approach might be to assign probabilities to various outcomes, and then weigh the economic impact of each. Needless to say, this is an onerous task. Instead, the human brain defaults to what Nobel prize winner Daniel Kahneman calls “system 1” thinking. We make an instinctual judgment, which is usually satisfactory for simple problems, but which can lead us astray if the problem is more complex.

In fact, faced with an uncertain but threatening situation, we often assume the worst. This approach helped us survive as a species. Is that a lion or just the wind rustling the tall grass? If we assume it’s a lion and we’re wrong, there are little or no consequences. But if we assume it’s just the wind and we goof, well, our genes—however brilliant at calculating probabilities—just didn’t get passed on. Such system 1 thinking leads people to sell stocks first and ask questions later.

3. Once spooked, our fear spreads.

Assessing the damage inflicted by the coronavirus epidemic on the global economy is only part of the story. The impact on our investment psyche is no less important. The longer we’re fearful, the greater the chance that we do permanent damage to our “animal spirits.” This increased risk aversion could have a long-lasting impact on stock prices. In fact, studies in behavioral finance have shown that fearful thoughts can translate into reduced risk-taking, even in unrelated areas of our life.

4. Complacency leaves us vulnerable.

The swift market reaction to the coronavirus was due, in part, to a previously lax attitude toward risk. The U.S. is in the longest economic expansion in modern history and we’ve enjoyed one of the greatest bull markets of all time. But beneath the surface, there are numerous financial risks that investors have been blithely ignoring, including an expensive U.S. stock market, global trade wars, an upcoming presidential election, enormous government debt, overleveraged companies, exceedingly low and negative interest rates, and an inversion of the yield curve. Yes, we have faced all sorts of risks in the past and gotten through them—and chances are we will get through the coronavirus epidemic, too. But it’s when risks are not being priced into markets that markets are riskiest.

5. “You can’t predict,” says Howard Marks. “You can prepare.”

If we couldn’t have predicted a “black swan” event like the coronavirus outbreak, what’s an investor to do? According to Marks, co-founder of Oaktree Capital Management, we can’t anticipate every risk. After all, if we could, they wouldn’t be risks. But by being cognizant of the investment climate—including where we stand in the economic and market cycle—we can prepare our portfolios for the unforeseen.

The most practical implication of this is something I call “countercyclical rebalancing.” Here is how it works: If our long-term asset allocation is 60% stocks and 40% bonds, not only should we rebalance from time to time, but we might also consider over-rebalancing. In 2009, investors were being paid a lot to assume stock market risk, which is another way of saying that expected stock returns were higher than normal. Countercyclical rebalancing would mean taking on a little more risk by, say, shifting to 70% stocks and 30% bonds.

Fast forward to 2020. Investors today are being paid far less for assuming stock market risk, especially in the U.S. A countercyclical investor, who would normally hold 60% stocks and 40% bonds, might shift to 50% stocks and 50% bonds. By lowering our stock allocation, we lower our portfolio’s expected return, but we lower its risk level even more.

You might call this market timing, but I think of it as risk management. There are times when the market pays us more for taking risk, such as 2009, and other times when it’s paying far less, like today. Note that this is very different from selling all stocks and going to cash. That’s true market timing—not something I advise.

6. It isn’t easy to buy when there’s “blood in the streets”—or coronavirus in the air.

The adage “buy low, sell high” is deceptively simple. The problem: When markets fall substantially, it’s almost always for a very good reason. While it’s easy today to look back at the stock market’s mouth-watering opportunities during the depths of the 2008-09 financial crisis, those were extremely scary times. Bank after bank was going belly up. The well-known investment expert Mohammed El-Erian relates calling his wife to pull out as much cash as possible from the ATM, fearing the banks might not reopen.

I don’t pretend to know what coronavirus will do in the months ahead. Will this pass like prior pandemics, such as SARS and H1N1? Perhaps. Will it wreak as much havoc as the measles virus, which is estimated to have wiped out 200 million people worldwide? No one knows—and that’s terrifying. Being a buyer of stocks is never easy, but it’s particularly difficult when there’s “blood in the streets.”

7. Volatility isn’t just noise.

Well-meaning financial experts tell us that stock market volatility isn’t really risk, but rather just noise. This may be true if you’re a machine. What if you’re human? Not so much.

In his book Misbehaving, Nobel prize-winning economist Richard Thaler explores the difference between “econs” and humans. Econs are perfectly rational beings that maximize their utility and have complete self-control. In a world of econs, market volatility is just noise.

But we humans experience volatility—and especially falling prices—very differently. We get far more pain from losses than pleasure from gains. Yes, the S&P 500 soared 28.9% in 2019 and is down just 7% in 2020, but I doubt many investors are comforted by that fact. Real humans also suffer from recency bias: What has happened lately seems like the most likely scenario going forward. In short, market volatility is risk because it feels risky.

8. Our risk tolerance collapses when we need it most.

Saying we’d be comfortable seeing our portfolio decline 30% is one thing. Actually experiencing it is entirely different. This is why risk tolerance questionnaires are all but useless. We simply don’t know ourselves that well.

I consider risk tolerance one of the thorniest concepts in finance. A key reason: Our tolerance is dynamic. Studies have shown that it rises with bull markets and declines along with share prices. The only way to really know how much risk we can tolerate is by living through market cycles. If we’re about to embark on a bear market, we should come out the other end with a better understanding of our true tolerance for risk. It could be a wonderful silver lining—if we have the presence of mind to pay attention.

John Lim is a physician and author of How to Raise Your Child’s Financial IQ, which is available as both a free PDF and a Kindle edition. His previous articles include Crash Course12 Financial Sins and 12 Investment Sins. Follow John on Twitter @JohnTLim.

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