When I am combing through our investment research I always look for defined market risks. I don’t want to miss anything. After all, risk matters a lot to our clients no matter what stage of life they are in.
When I see risks that are familiar to me, I have two reactions. The first is relief that our assessment matches what researchers are thinking. Our Portfolio Committee then has a much better chance of staying on top of market conditions. The second reaction is, “But what am I overlooking?” Too often when investors all believe the same thing, something else happens. I call it surprise risk.
Surprise risk has bitten investors many times (1987’s Black Monday, the dot.com bubble and, of course, 2008 are a few examples of more dramatic risk events). In hindsight investors look for clues they failed to see. Sometimes clues are ignored because they become lost in the morass of information that floods inboxes from so-called experts. At other times the clues are complicated and not easily understood, such as the derivative markets that dominated trading behind the scenes leading up to the Great Recession. And then there are times when the unexpected just happens, and investors react (deservedly or not) with fear. Case in point: 2016’s miserable start to the year was compounded by market psychology that placed fear on top of concerns for the economy.
Before I go any further, I should note that I am not feeling as if there is a lot of market risk right now. The likelihood of a recession in the next twelve months is deemed to be small by most economists. The VIX (a measure of volatility) has been remarkably low and stable for the last six months. This earnings season is turning out to be better than expected. And while most analysts say stock prices are high, stocks still appear reasonable when compared to the returns that bonds offer.
So it is a good time to talk about risk – when the market outlook is calm and investors are feeling confident. And who knows, it might be a perfect time for surprise risk, given I am not expecting it. So let’s prepare for it.
I’ll start with some differences between known and unknown risk.
One key point about market risk is that when it is known, the markets tend to factor it into prices.
Let’s take the political risks right now. After the election, markets priced in future stimulus measures regarding taxes, infrastructure spending and regulation. Many analysts noted that the markets got ahead of themselves. Between around March 1st and May 1st, when investors began doubting the timing or extent of stimulus, markets priced this postponement in by taking a pause. With a housing bill passed in the House and tax reform outlined this past week, the markets are starting to acknowledge stimulus as back on the table with a bump in prices.
Known risk is often tied to data on the economy. We talk a lot about interest rates, inflation, GDP, unemployment, earnings, etc., all of which are tracked with indicators and charts that attempt to show trends in the economy. In other words, known risks can take time to assess and are constantly under revision and updating. While expert opinion can vary, everyone is mostly looking at the same data.
A definition of surprise risk might be risk that cannot be factored into market pricing ahead of time. The risks appear suddenly and are often tied to factors that are not easily measured. Four of those factors are quantitative trading, illiquidity, herding and event risk. (Quick caveat: this does not mean that these elements are necessarily risky in and of themselves, only that when markets unexpectedly swoon, aspects of these factors are often present.)
Quantitative trading is usually associated with algorithmic trading, statistical arbitrage and high frequency trading. The definition alone is hard to understand. Add in that the trading is often invisible to the average investor, and unexpected price changes are very possible. Flash crashes, which happen without warning, are an example of the fallout that can happen when computer formulas go awry.
Illiquidity: Trading usually goes smoothly as long as there are enough buyers to match sellers. Securities can become illiquid (hard to sell) when trading is thin and/or the buyers disappear, which can be fueled by investor fear and market psychology. During the 2008 financial crisis, esoteric mortgage securities, junk bonds and similar securities experienced major meltdowns because investors’ positive impressions of these assets turned negative and buyers disappeared.
Herding occurs when too many investors pile into a popular trade. Most of the time trading is fairly well balanced (think of a boat full of investors). But if lots of people are placing the same bet (and rushing to one side of the boat) instability can result, especially when a trade starts to unwind. Bubbles lend themselves to herding. Tech stocks were a fantastic trade in the late 1990s – until they weren’t.
Black swans: these are unusual and unanticipated events that happen infrequently and irregularly but can result in extreme consequences. Who saw the market crash of 1929 or 2008 for that matter? Black swans can also be smaller events such as the Japanese earthquake which had a severe impact on their economy for several years.
If you are reading about a particular risk, it is probably already known, and the markets are in the process of factoring it in to prices. You may not even notice the changes, and think of the volatility as the normal ups and downs of the market. Surprise risk, in contrast, usually jolts investor emotions potentially resulting in hasty selling to alleviate anxiety.
Sometimes you see risk coming; sometimes you don’t. But no matter whether it is known or unknown, risks should be treated the same way. Check your emotions at the door; evaluate the extent and cause of the underlying problem; and make adjustments to your portfolio judiciously and only after careful consideration.
Betsey A. Purinton, CFP® is Managing Partner and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at firstname.lastname@example.org.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.