Betas, Sharpe Ratios and the other typical metrics of investment risk are so 20th century. This century has produced new twists that often defy traditional views of investment risk.
Here are some realities of investment risk in the modern age:
How the low interest rate environment changes everything
Essentially, risk management is about choices - choosing one investment over another because of their respective risk/reward characteristic. However, the low interest rate environment has skewed those choices, for both investors and policy makers.
Here are three ways the low interest rate environment has made risk management more difficult:
1. It cuts down on monetary policy options
Cutting interest rates has been the Federal Reserve's go-to move during financial slowdowns, but with the Fed funds rate close to zero, there are fewer monetary policy options open if the economy needs a stimulus.
2. It penalizes investors for avoiding risk
Historically, when investors wanted to avoid risk, they could still earn a few percent in a savings account, and even more in government bonds. Now, with savings account rates near zero and Treasury bonds yielding less than 3 percent, being risk-averse is a more costly exercise. Trying to avoid big losses can mean having to accept steadily losing purchasing power to inflation.
3. It drives people into riskier assets
As a consequence of the unattractive alternatives offered by savings accounts and bonds, investors are being driven into the stock market. This is not because stocks look so good, but because interest rates make lower-risk choices unappealing.
High valuations can make portfolios riskier than meets the eye
The stock market has been more or less flat so far this year, but that apparent calm belies the true degree of risk in stocks right now. Here are some reasons to be concerned:
1. Low rates have made valuations artificially high
The price/earnings ratio of the S&P 500 has been above 20 since the beginning of the year, which is a fairly steep valuation this deep into an economic cycle. Low interest rates can be credited with driving valuations higher, which means a rise in rates will remove an important source of support for stock prices. It is a little troubling to think that prices could be sent tumbling just by interest rates returning to normal.
2. Valuation affects returns, even for low risk stocks
In a May/June 2015 issue of the Financial Analysts Journal, Luis Garcia-Feijoo, Lawrence Kochard, Rodney N. Sullivan and Peng Wang demonstrated that the investment success of supposedly low-risk stocks depends greatly on the price paid for those stocks. This is especially sobering when, in the aftermath of the financial crisis, so many investors have sought low-risk strategies, driving valuations on those types of stocks up.
3. Backward-looking risk measures may reflect the opposite of the future
Traditional risk management techniques center on the notion that risk is measurable. What is readily measurable about investments is their past performance. As a result, risk management often relies on the assumption that the future will repeat the past to some extent. This assumption becomes especially problematic when the past several years have been dominated by a falling interest rate environment that has driven rates down to almost zero. There is virtually no way that these conditions will be repeated going forward, and they very well could be reversed if interest rates rise to more normal levels.
Why international diversification has its limits
A possible solution to concerns about the U.S. economy and stock market is to invest internationally, but the way markets have developed international diversification only has limited value as a risk management technique, for the following reasons:
1. Trade inter-dependence
Trade among nations means their economies are less independent of one another than they used to be. In particular, it is hard to completely diversify away from U.S. economic risks because so many nations are dependent on the U.S. as a consumer of their goods.
2. Monetary influence
The Fed does not have complete independence in making monetary policies because there can be adverse currency consequences to stepping too far out of line with the interest rate policies of other nations.
3. Global investment momentum
Another study in the May/June 2015 Financial Analysts Journal, by Timothy K. Chue, Yong Wang and Jin Xu, found that international diversification did little to reduce momentum-driven risks because investor behavior tends to follow similar patterns across borders.
The most devastating risks are the unexpected ones. The best way to cut down on the possibility of being caught unprepared is to challenge your assumptions. This means not being comforted by traditional risk management theories, and instead considering what could go wrong under today's conditions.