Revisiting Risk in an Euphoric Market Environment

Every investor with experience in the stock market should understand there is a relationship between return and risk. The existence of a trade-off between the opportunities for gain against the possibility of loss is not in debate. Nor are the mathematical calculations behind each side of the equation subject to argument. However, where investors do take sides is what the definition of risk really means. There are three definitions of risk broadly categorized as:

• The risk of absolute loss
• Volatility of short term returns
• Opportunity loss

THE RISK OF ABSOLUTE LOSS is straightforward but nevertheless deserves some commentary. Stock certificates have no maturity date, so theoretically can be held indefinitely. The risk of absolute loss is not defined as a capitulation by investors who sell stock in a company still operating after a dramatic drop in the price. The risk of absolute loss (i.e. 100%) in a failed company represents a very small percentage of public companies over history.

VOLATILITY OF SHORT-TERM RETURNS is a much broader definition of risk and generally the most accepted view by investors. There are two sides to volatility of returns however; there is upside volatility (which is the kind investors want) and downside volatility (which most investors don’t want). The emotional reaction by investors to downside volatility is very real, as it may force selling stocks in a down market as the shift to preserving capital becomes paramount.

OPPORTUNITY LOSS is the subject of this letter and is defined as the risk of being out of an asset class that performs well over a long period of time. Opportunity loss is inversely correlated to the time horizon of investors as the shorter the time horizon of an investor the greater the risk of a lost opportunity.

Edison concisely makes the point. For example, the best time to raise exposure to the stock market is when the most number of investors believe the opposite (i.e. the market dressed in overalls). For investors, the metaphor of work Edison expressed can be translated into the patience required the greater the volatility in the asset class.

Consider the graph below, which illustrates the cumulative price return of the S&P 500 Index from year end 1977 to mid-July 2017 (39.7 years). The annualized price only return over this period was 8.5% per year, which including dividends would generally be regarded as a robust, even attractive long-term investment return. However, the expression of 8.5% annually grossly overestimates the smoothness of this return. The graph breaks down the 58 best weeks in the S&P 500 and evaluates the cumulative return of those weeks vs. the cumulative return of the remaining 2,005 weeks constituting the full period. The 58 best weeks in the S&P 500 since year end 1977 represents only 2.8% of the number of weeks in this study, but more than 100% of the cumulative return. That’s the work.

Patience is a critical common factor among history’s most successful investors. There will always be reasons not to invest in an asset class, and that list will grow as investors become fearful, which history suggests is a great time to buy. There will also always be periods when good returns are extrapolated into the future, which history suggests investors become too complacent. While there is a vast range of potential scenarios and outcomes in between, our observations lead us to believe the latter situation may be the most accurate understanding of today’s environment. Regardless of what lies immediately in front of equity investors, however, the best long-term returns are those that meet expectations based on a definition risk – it stands to reason, then, that investors with the clearest definition of risk will be likeliest to meet long-term expectations.

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