When Low Risk Isn’t Low Risk

03/14/21 | Birchbrook Team | Birchpapers

Much has been made in the news lately about March marking the one-year anniversary of the COVID-19 pandemic. Of course, it is debatable whether March is the correct reference point. In a recent article, The Atlantic appropriately argues that there isn’t a single pandemic anniversary: “The pandemic…did not come to everyone on the same day, or even in the same month, and nor will its anniversary.” The article points out that, for the families of the over 526,000 Americans who have died as a result of this terrible disease, each will mark and remember a different time and place.

Thinking back to this time last year, life was rife with uncertainty. State and local governments had just started to implement lockdowns. No one knew how long the shutdown or the pandemic would last, and it was estimated that the human toll would be incalculable. The lockdowns drove companies out of business and put an unprecedented number of people out of work. It was uncertain whether simple acts like going to the grocery store or pumping your own gas could lead to infection. It was a scary, scary time.

During frightening and unprecedented times, it is a natural human reaction to recoil in fear. When life is scary and uncertain, we immediately and instinctively do what we can to protect those people and things most important to us. For investors, this might mean selling investments to preserve cash and wealth.

At the height of market panic last year, stocks saw daily drops of 8-12% as investors sold indiscriminately in their rush for the exits. This reaction was perhaps natural, but it was not entirely rational; high-quality investments were sold alongside low-quality investments, creating significant mispricing opportunities in hindsight.

The market, always forward-looking, quickly identified these mispricings. By March 23, 2020, the market had reached its low point – even though the pandemic had just begun. Since then, stocks have increased over 75%. While March might not be an appropriate anniversary for the pandemic as a whole, this coming March 23rd will mark the anniversary of the start of our present bull market. In total, the pandemic-driven bear market lasted just 33 days, the shortest on record.

This brings us to a discussion of risk. There are many risks to investing, some of which are quantifiable. We often think of risk in terms of an investment’s potential for volatility (i.e. standard deviation) or an investment’s potential for loss. These risks were on full display during the COVID-19 sell-off.

However, there is also risk in taking too little investment risk. The less exposure an investor has to growth assets, like stocks, the more exposure he will have to inflation. We don’t always notice inflation, but it eats away at the value of our portfolios slowly over time, making it one of the most insidious types of risk.

Let’s consider Joe. He is fearful of stock market volatility and has invested all of his money into low-volatility investments like bonds and cash. The nominal value of Joe’s portfolio might remain stable over time, which gives the perception that the strategy is low risk. But the real value of Joe’s portfolio is likely to decline over time, at least if interest rates remain low. An investor can calculate the real return on his portfolio by subtracting inflation from his net investment returns. For example, if Joe earned 1.5% on his bond portfolio last year but inflation was 2.0%, then Joe experienced a negative real return of 0.5%. This negative real return represents a decrease in purchasing power and a decrease in real wealth.

A decrease in real wealth? That sounds risky! Over the years, if Joe were to continue earning negative real returns, then those returns would compound and Joe’s future purchasing power would be significantly eroded. For example, if Joe were to experience negative real returns of 0.5% per year for 10 years, then his future portfolio would have roughly 95% of its original purchasing power. This dynamic would be even worse if Joe were to take a distribution from his portfolio each year on top of the negative real return. If we were to assume a 3.0% distribution rate on top of the 0.5% negative real return, then Joe would be left with just 66% of his original portfolio value ten years from now – all while being invested in a “low risk” strategy!

At the end of the day, some risks are more certain than others. When investing in stocks, an investor can expect a lot of volatility, and this is a type of risk. But although people can and do lose money investing in stocks, the risk of permanent loss in the stock market is neither certain nor guaranteed. If an investor is appropriately diversified and resists the need or temptation to sell during market corrections, then she might never experience a permanent decrease in real wealth. Stocks might move all over the place at times, but history has shown that stocks, broadly speaking, overcome temporary setbacks and increase in the long run. The market’s behavior over the past year well illustrates this fact.

Inflation, on the other hand, is certain (or just about). If an investor doesn’t earn enough investment return to overcome inflation year after year, then he is almost guaranteed to see a permanent decrease in real wealth over time. It goes without saying that any strategy guaranteeing long-term losses should be avoided.

Uncertain risk of large losses versus the certain risk of small losses – this sums up the contrast between investing in stocks and investing in ultra-safe bonds and cash, at least while interest rates are so low. An investor should rarely be overexposed to either risk, but conservative investors cannot afford to ignore the latter.