Estimating Market Risk

What do you think is the biggest problem for the individual investor?  My vote goes for the ability to handle risk.  While investors grasp the concepts of risk and reward in a general sense, the implementation is a problem.

Before reading on, please answer this question.  On average, what is the probability that the market will decline by 7% at some point in the next three months?

To understand and manage risk requires several steps:

  1. Determine your personal risk tolerance.
  2. Understand the normal market trading ranges and volatility.
  3. Have a method to recognize when there is exceptional risk.

The Risk Project

Over the last several months our team has been working on a project to identify the "best times to invest."  One element of this research is the question of estimating market risk.  I have shared our weekly risk assessment on my Weighing the Week Ahead series, but today I would like to provide a little more information.

The basic concept is that some amount of risk (let's call it X), is absolutely normal fluctuation.  This is to be accepted and appreciated.  If Mr. Market did not ever offer any bargains, the investor could not generate any edge.  Anyone investing in stocks should expect to see this variation and accept it as completely normal.

For most investors the problem is that any selling is accompanied by a media assault proclaiming this to be the next "big one."  With 2008 fresh in the memory, this is an easy story for most of the media.

Most people are hard-wired to fear losses more than to appreciate gains, part of the reason that investors consistently under-perform a buy-and-hold approach.

If you were close to the 24% answer on the drawdown question, you are one of the smarter investors out there!

The Solution

Let's return to the three steps.

  1. Personal risk tolerance.  Do not cheat on this.  If you overstate your tolerance, you will bail out of your investments at the worst possible time.  Adjust your risk through your asset allocation.  If you do not know how to do this, you need an investment advisor.  (Look for one who is honest and does not profit from trading your account — one whose interests are aligned with yours).
  2. Normal market risk.  Let us suppose that you choose a 7% decline within a three-month period as "X."  On any given day, the chance of this decline is 24%.  (The chance of a 7% gain is 36%).  Most investors have no concept of normal risk or the fluctuations to be expected.
  3. A system for recognizing exceptional risk.  This is the key.  WIthout such a method, the investor lives in a perpetual state of fear.  This is the point of our risk project.

An objective assessment of risk cannot be based upon what most observers incorrectly refer to as the "fundamentals."  By fundamentals, most pundits mean a list of worries they use as talking points when they get on TV.  There are always worries.  Whenever some are eliminated, there will be a fresh supply.  The real fundamentals are expected corporate earnings and interest rates, subjects carefully avoided by the extensive perma-bear community.

To avoid this problem the investor needs a forward-looking method, something that has proven predictive ability.  That is the mission of our risk project.

We have some promising results, but we are not yet ready to publish.  Why mention this now?  Mostly because it is timely — the risk measures are not threatening.  More to come.

Meanwhile, all of the other key factors for the long-term investor look very good — corporate earnings, corporate balance sheets, interest rates, and inflation expectations.  Economic forecasts are weak, but the recession probability is low.  Meanwhile, prices are already building in a recession level of earnings.

I could write more on these latter points, but today's piece is about risk.  For those investors who are scared witless, let me ask as simple question:

Do you have a means of measuring risk, or do you respond to the unquantifiable barrage of commentary?

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  • scm0330 August 4, 2011  

    I have two quibbles: first, could you be a little more specific on why you believe that recession probability is low? I’m not seeing much to crow about across jobs data, durable goods, ISMs, you name it. (I consider sub-1% GDP equivalent enough to recession, btw.)
    Second, I wonder about the St Louis Fed as an indicator of financial risk. Much of it is grounded in rates and spreads; could it be that, with short rates held low by decree, and longer rates in freefall (pending economic contraction?), this indicator is giving us a false positive as to the health of markets.
    Maybe stated another way (and respectfully; I’m not trying to break your chops, Jeff), if your indicators give such a wide range of “normalcy,” what are they really indicating? The current selloff has been painful and looks to worsen, but it’s not reflected in the gauges and dials that you rely on for a tell.

  • Proteus August 4, 2011  

    Jeff, you’re confusing me by interchanging the terms risk and volatility. In step 2 of The Solution, do you mean Normal Market Volatility? And it’s sure not clear to me about exceptional risk (good) or exceptional risk (bad). Looking forward to you expaining more in future writings.
    Does risk tolerance change over time? I think there’s no denying the market’s character has changed a lot over the past two decades. 20 years ago, a 7% decline would have been a buying opportunity. Now, people are rightfully worried, easy media story or not.
    I had to laugh when you asked the question about the probability of a 7% decline – I guessed about 40%, but then thought “Sure, and there’s a small chance we’ll see it all in one day”.

  • oldprof August 4, 2011  

    scm — We continue to experience a period of growth that is significantly below the long-term trend. For most people, it feels like we never emerged from the recession. This low growth environment has been enough for robust earnings and good investing. I’ll do a separate article on recession forecasting.
    You ask a good question about interpreting the SLFSI data, and one that I have been studying carefully. The key point is that the interest rate spreads have always been at least partly the result of Fed policy. Why think that this is different? The QE action reduces the yield slope by a little. Some have estimated that QE II was the equivalent of 75 bps in the Fed funds.
    To summarize, I think the implied risk would be even lower without the QE actions. As I said, we are reviewing all of this in the search for an objective, data-based indicator. You can see from the chart that this approach was effective in 2008.
    More to come, and thanks for joining in.

  • oldprof August 4, 2011  

    Proteus — I’ll try to sharpen up the terminology as I write more on this.
    Most people confuse volatility with downside risk. Volatility goes both ways. Risk tolerance is a personal matter. It only changes if your personal circumstances change. Sometimes people learn that their risk tolerance is not what they thought it was, which is why I emphasized the need for honesty.
    Your guessing is better than most!

  • Angel Martin August 4, 2011  

    Jeff, I’ll be interested to see what you come up with for your exceptional risk project.
    One thing I always keep in mind on this topic is the strong seasonality of really big market declines. We have a 400+ year history of market panics, crashes, financial crises etc. and all of them, as far as I know, occurred in the Spring or the Fall. (the closest to an exception was the Japanese market in 1990, which was in late december.)
    I assume that the same size negative shock on the market can have a different effect in August vs October. And that a high reading on the St Louis Fed Index is not as important in January as it is in April.
    Jeff, are you modelling for seasonality in your “exceptional risk” model?

  • Angel Martin August 4, 2011  

    Actually, looking at 1998 again, the sharpest declines were in july and august – so that’s another exception…