The four-letter word of this bull market is, without question, “risk.” But it’s a four-letter word not in the sense that anyone’s offended by it but in the sense that it’s become virtually unutterable. Even in the wake of January’s remarkable volatility, thinking about risk–let alone worrying about it–seems to mark you as someone confined by old paradigms, perhaps even someone who thinks about things like–gasp!--what companies are actually worth.
Now, as I’ve argued here more than once, this supposed opposition between old and new paradigms of stock valuation is essentially imaginary. This stock market is, in fact, very much concerned about what companies are actually worth, and is doing its best to figure that out. It’s just that the level of uncertainty about the future of many companies, indeed of entire industries, is higher than it has been for decades, which accounts for most of the volatility that’s become an everyday reality of this market. The potential payoffs for success in this economy are now so huge, and the costs of failure so dramatic, that when the market changes its collective mind on just how likely success or failure is for a given company, the impact on that company’s stock price is similarly dramatic.
But if it’s a mistake to think that this stock market is, as a whole, paying no attention to economic fundamentals, it’s not a mistake to think that investors, as individuals, are devoting almost no attention to the riskiness of their investments. Somehow, the fact that the price you pay for the possibility of a high upside is the possibility of a very real downside has eluded investors. The consequences of this are not going to be pleasant (for investors, if not for the market as a whole).
There are a host of reasons for the virtual disappearance of risk as a constraint on investor behavior, and some of them are very good reasons. The best-known measure of risk is beta, which essentially tells you how big a stock’s moves–up and down–are relative to the market as a whole. (A company with a beta of 1 moves in line with the market, while a company with a beta greater than one oscillates wider than the market does.) And in the last decade, we’ve seen a host of high-beta companies deliver remarkable performances over long periods of time and come to dominate the popular view of the stock market. Microsoft, Cisco, GE, America Online, Wal-Mart: These companies have delivered extraordinary and consistent returns to investors while also being, in terms of beta at least, risky. But if Microsoft, which at the end of 1999 had risen an average of 1 percent a week for its entire history as a public company, is risky, then worrying about risk seems understandably silly.
At the same time, the discussion of risk has been confused by the traditional economic formulation “high risk, high reward.” This formulation is correct, in the sense that the only reason for investors to invest in risky stocks is the possibility of higher rewards, and so high-beta stocks deliver better returns over time than low-beta stocks. But the formulation seems, of late, to have been transformed into a kind of promise, so that investing in risky stocks doesn’t offer the possibility of higher rewards, but rather the guarantee. All it takes is a glance at all the Internet companies whose stocks now trade below their initial offering prices, or a glance at the bankruptcy listings, to realize that high-risk stocks are called that for a reason. But that’s a glance that not too many people seem to be taking.
There’s also the simple fact that the market keeps going up, which means that it’s easy to delude yourself that risk comes without a cost. Take, for instance, those fund managers who last year loaded up their funds with tech and Internet stocks, and as a result crushed the S&P 500. The problem is that if you want to know how they really performed as managers, you have to adjust their portfolios for risk, since it’s important to know if this year there’s a good chance those funds will not outperform again. In a simpler sense, you can just compare their performance not to the S&P but to the Nasdaq (which has a much higher beta than the market as a whole). And next to the Nasdaq’s 85 percent return in 1999, a tech fund that returned 65 percent is doing badly, not well.
Finally, many (perhaps even most) investors have taken to heart the virtues of long-term investing. In his book Stocks for the Long Run, Jeremy Siegel showed that there has not been a single 30-year period in history where stocks were not a better investment than bonds, and that there has not been a single 30-year period–even one encompassing the Great Crash–where stocks did not deliver a positive inflation-adjusted return. In other words, in the long run stocks are less risky than bonds. So perhaps worrying about risk is, in fact, pointless.
The problem is that Siegel’s numbers are true, as he himself says, of the market as a whole. They are not true of individual stocks. This point should be obvious, but it’s not. Individual stocks are, in fact, still riskier than bonds. Companies go out of business, or simply start to do worse than they did in the past. Companies are often overvalued and cannot live up to expectations. And this means that if your portfolio is riskier than the market as a whole, you have a much better chance of losing money over time than if you were invested in an index fund.
The gospel of long-term investing is the right gospel to be preaching, but for the vast majority of investors it’s only the right gospel if it comes accompanied by the dogma of indexation and an awareness of the idea of risk-adjusted returns. After all, you can make a lot of money in one night at the craps table. But if you keep going back, eventually it’s the casino that gets rich.