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:
- Determine your personal risk tolerance.
- Understand the normal market trading ranges and volatility.
- 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!
Let's return to the three steps.
- 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).
- 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.
- 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?