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A Word in Your Ear

Updated: May 17, 2022

For such a simple word, risk is quite hard to define. It is generally agreed that it pertains to danger of some sort, but that is where the consensus appears to end. Even the etymology is unclear, though some believe it can be traced back to the classical Greek word ριζα (rhiza) meaning root. In Homer’s Odyssey, Odysseus attempted to save himself from the sirens by grabbing the roots of a wild fig tree. More broadly, the word meant “root, stone, cut of the firm land” and was a metaphor for “difficulty to avoid in the sea”. In other words, it related to danger, from whence came the modern connotation.

"The fact that Japan is far away and the dismal bond performance is long ago may be clouding our judgment"

In the investment world, the term risk is defined in various ways. Thanks to Harry Markowitz, most think of investment risk as the volatility of market prices. In his 1952 paper Portfolio Selection, Markowitz set out a framework for constructing portfolios, making the seemingly innocent assumption that “the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing”.

Later in the paper he wrote, “The concepts ‘yield’ and ‘risk’ appear frequently in financial writings. Usually if the term ‘yield’ were replaced by ‘expected yield’ or ‘expected return’, and ‘risk’ by ‘variance of return’, little change of apparent meaning would result.”

From this moment forth, volatility would be seen as a risk to be avoided, rather than an irritant to be tolerated.

The periods that should matter for those saving for retirement are long ones not short ones. Ultimately, it is the goal that matters, not how it is scored. Indeed, this was the key idea of a recent investment expert panel discussion. The panel suggested that volatility should be defined in terms of whether you reach your investment goal, rather than short-term volatility.

The former relates to permanent loss of capital – if you fail to achieve your goal then the shortfall is one you can never make up. Short-term volatility on the other hand should simply be viewed as a cost of seeking to achieve your long-term goal rather than something to avoid – unless you have an absurdly unambitious goal, your portfolio will always have its ups and downs from year-to-year.

The panel went on to say that volatility defined as they suggested disappears over time, essentially because the long-term returns from equities and bonds over the longer term are reliable. But is this true?

A US Treasury investor would lost 48% of his real capital from 1900 to 1920, a period of 20 years. Had he begun investing in 1940 he would have lost 63% over the next 41 years. In Japan, an equity investor starting out in 1989 would have seen a decline in the real value of his portfolio of 70% over the next 22 years.

The fact that Japan is far away and the dismal bond performance is long ago may be clouding our judgment. Furthermore, long-term prospects today for equities and bonds may not be that rosy. Famed investor Jeremy Grantham warned only recently that, “the stock market will ‘break a lot of hearts’ in the next 20 years”.

As for bonds, with the 30-year inflation-linked Gilt yield at -1.8% currently, your total real return to maturity is a loss of 42.1%. Moreover, real losses on straight (nominal) Gilts will be even worse than those on linkers if inflation over the longer term is higher than the 3.4% currently anticipated, which it might well be.

These are the stark realities. We can either bury our head in the sand or address them.

If you choose the latter, you will have to accept that traditional safe assets such as Gilts or Treasuries are no longer safe and that for safety you need to look elsewhere. Examples might include infrastructure trusts that offer mid-single-digit yields and whose revenues are linked to inflation.

You will also need to start taking greater advantage of periods of equity market weakness. If Grantham is right, equity market declines in coming decades are either going to be bigger or more frequent, or both. Responding to them in the right way will be paramount.

The big risk today may be the risk of doing nothing.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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