Risk and return revisited

“Though shalt always earn a return on your money” is written nowhere. Yet due to the continuing success of who has gone “risk on”, forgotten the switch and remained invested for the last few years, any intimation of prudence has fallen on deaf ears.

Once upon a time (ten or so years ago, but it feels much earlier than that) there was a normal “risk curve.” All assets were lined up along the horizontal axis, in order of increasing level of risk, with their corresponding expected returns shown on the vertical axis. For example, cash paid a nominal positive return, bonds would yield somewhat higher than cash and equities higher still. Life in the markets looked like this:

Figure 1

Investors were more or less happily set with their objectives and distributed their assets accordingly (with a few clueless ones hobbling along):

Figure 2

Then came the financial crisis and the Fed decided to protect the “system” by aggressively lowering interest rates (green arrow) and keeping them there for a long time. The risk curve slowly but surely moved like this:

Figure 3

The move in the risk curve was also the result of investors who, realizing the semi-permanent nature of the Fed’s policy (and coining the term “new normal” as they went along), decided to deviate from their objectives and went on to bid up asset prices across the risk curve. They began migrating en masse towards riskier assets and portfolios (the clueless, still hobbling, were now joined by a few mad ones because some investors are always mad):

Figure 4

In the rush to avoid low or negative cash rates (like the plague), most investors felt essentially “forced” to seek higher risks and forgot that they still had to face the same level – or higher – of potential drawdowns in the future:

Figure 5

In summary, we went from:

Figure 6

to:

Figure 7

Figure 8

This is why prudence may not be such a bad idea: lower-risk assets yield less but are safer. To put it another way, if asset prices are high, and prospective asset returns are low (as the current risk curve indicates), why keep positions unchanged? Why not buy some “insurance” by favoring a more prudent investment strategy?

Unless of course you are one of those rare earthlings with extraterrestrial abilities, capable of getting in and out of the markets at exactly the right time. Even then, it pays to remember: just because you got away with it does not mean you didn’t take any risk.

Find that “risk off” switch. Now.