Our Mixed-Up Ideas About Stock Investing Risk

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Valuation-Informed Indexing #139

by Rob Bennett

No one deliberately tries to drive in a risky manner.

No one starts out a school year saying “I want to risk getting an “F” this semester, so I am going to try to get in the habit of never doing homework.”

No football player practices how to drop the football with the aim of increasing the risk of a turnover.

It drive me crazy that Buy-and-Hold investors describe how investing works in such a manner as to suggest that risk is a good thing. They tell investors that stocks pay high returns because they are a risky asset class. The clear suggestion is that taking on risk is inherently a good thing.

The idea of an effective investing strategy is to avoid risk.

Yes, there are certain risks that an investor must take on. A football player doesn’t avoid the risk of a fumble by refusing to suit up and go on the field. And an investor must be willing to purchase asset classes more risky than Certificates of Deposit.

But there is a deep confusion in this field concerning the risk question that I believe must be overcome if we all are to become more effective investors.

The confusion stems from the twisted notion that it is because stocks are risker than money market accounts that stocks provide higher returns.

Stocks generally offer higher returns than money market accounts. That much certainly is so. But how did this idea catch on that the reason is that stocks are more risky?

I believe that there is a fundamental error in the conventional thinking about how stock investing works that placed us on this wrong track.

The economists started with a premise that all asset classes should offer the same return unless there is some logical cause for the returns to differ. Then they noticed that stocks pay a higher return. So they felt a need to come up with an explanation. They came up with the “Equity Risk Premium” concept. Stock investosr are paid extra because they are more willing to take on risk.

Is there any evidence that this is so?

I like to point to the circumstances that applied in January 2000. RIsk-free asset classes like TIPS and IBonds were paying a guaranteed return of 4 percent real. And a regression analysis of the historical return data showed that the most likely annualized ten-year return for stocks at the time was a negative 1 percent real. The far more risky asset class was paying the far lower return. There was no risk premium. There was a risk penalty.

The risk premium theory has failed to explain the realties. We need a new explanation of why stocks offer higher returns than alternate asset classes.

It’s not hard to come up with one.

Why does it have to be that stock returns are dependent in any way on the demands of potential buyers? My thought is that the average annual stock return of 6.5 percent is what it is because that is the return that has historically been supported by the productivity of the U.S. economy. The return is a given. There are no market forces pushing it higher or lower.

In contrast, market forces really do influence the returns paid by Certificates of Deposit and Money Market accounts and IBonds and TIPS. Banks that want to sell their CDs must offer them at attractive prices. At times when stocks are doing well, they must come up with a good deal to have much hope of persuading investors to buy. At times when stocks seems scary, they can get away with setting very low returns for their CDs.

No one wanted to hear about non-stock asset classes in 2000. So the return had to rise to 4 percent real for the banks trying to sell them to be able to do so. In contrast, stock investors had borrowed huge amounts from future investors to finance the bull market of the 1990s. So reestablishing the long-term average annual return of 6.5 percent real required a long stretch of time in which stock returns would be in negative or slightly positive territory. Market forces pushed the returns on the safe asset classes up much higher than normal while overvaluation pushed the return on the risky asset class much lower than normal.

It could be said that perceived risk plays a role in what stock return applies. Stocks are virtually a risk-free asset class when selling at the prices that applied in the early 1980s. But they are perceived as being a high-risk asset class at such times. And the reverse applies at a time like the early 2000s.

But if it is perceived risk that causes high stock returns, we cannot say that investors are being compensated for being willing to take on risk. Perceived risk is not real risk. There was only one direction in which stock prices could go in the early 1980s. Stock investors were not being compensated for their willingness to buy a risky asset class. They were being compensated because they were able to buy stocks at discounted prices and enjoy the ride up.

These distinctions matter.

Many stock investors reject claims that they should lower their stock allocations at times of high prices on grounds that it would be a mistake to show a reluctance to take on risk. No! No one should ever take on risk for the sake of taking on risk. All investors should calculate the risk they take on and the return they are likely to obtain from stocks at the given price level that applies when they are considering a purchase and then go with stocks only if the long-term value proposition available from them is superior to that offered by competing asset classes.

ASSUMING a benefit from risk is the worst of all worlds.

You can avoid risk if you don’t like it.

You can accept risk if you calculate it and it makes sense to take it on.

NEVER assume a benefit just from the act of taking on risk.

Rob Bennett has recorded a podcast titled “The Case Against Valuation-Informed Indexing.” His bio is here. 

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