Years ago, in 1988 and 1989, we would frequently jog in Riverside Park in New York City, taking a route along Riverside Drive from Columbia University down to 72nd street, and returning through the park to the area near Riverside Church. When finished we would sometimes meet up with other runners at a water fountain and exchange greetings, make small talk, then go our separate ways. It is one of our more pleasant memories of living in New York and working on Wall Street, at a time that now seems quaint, when many small, old-line investment firms remained in what was still mostly an analogue world. Computerized systems were already impacting the markets, but the Internet and high frequency trading were many years away. Business was conducted in the traditional way, with brokers hawking stocks and analysts producing tomes delivered in print. Our group at the fountain would never have dreamt of staying in touch via email or social media.
We describe this personal vignette because we often think about the period since the beginning of our connection with Wall Street—a span of time that has reached 35 years—and about the changes and upheavals we have witnessed. The investment world in the early 1980s was depressed by recession and high interest rates, but within several years we experienced a complete market cycle—a period of exuberance, when stock traders felt that nothing could go wrong, followed by the sudden crash of October 1987. In the last years of the decade we were still in the shadow of that traumatic event, but recovery was relatively swift, leaving few ill effects (unlike the impact of the big downturn of 1973-74, which had taken nearly a decade to overcome). After a few years public interest in the markets recovered, and stocks rose to blowout levels in the bubble of the late 1990s.
The revival of spirits after the 2000 collapse was similarly rapid. That downturn was largely confined to the technology sector, while the broader stock market rose nicely, leading to a period of exuberance captured by the now notorious remark by a Wall Street banker, “as long as the music is playing you’ve got to get up and dance.” But the recovery from the much more serious crisis of 2008-09 has been more circumspect and hesitating, with little of the enthusiasm felt in previous eras, in spite of a tripling of share prices since 2009. The environment is more akin to that of the 1930s; despite a dramatic rise in stock prices from the 1932 bottom, the public’s aversion to stocks after the Great Crash persisted for decades. There are major differences between that era and the current one, however. The Great Crash crushed business valuations, and they remained depressed for a long time thereafter, whereas the rise since 2009 has brought market averages and valuations to record levels. It is difficult to envision a long period of expansion ahead of us, as one could have with hindsight, in, say, the late 1940s.
So where does 35 years of observing the markets leave us now? Above all, these years teach us that no amount of experience can help to predict market direction; markets just do what they do, frustrating those who try to divine future events from their behavior. Experience helps us evaluate risk, as well as sense opportunity. The exuberance typical of highflying markets may now be camouflaged by the shift to “passive” investment vehicles, but the same “the market will take care of us” attitude that gives false confidence to speculators lies behind the current popularity of indexing. At a time when valuations are historically high and good investments scarce, experience, and history, teaches us that risk is elevated.
The evaluation and avoidance of risk are essential to proper investing. Investment implies, above all, the preservation of capital. We cannot eliminate risk, but we aim to reduce it as much as possible, and strive to earn a suitable reward for the risks that we do accept.
In speculation, risk plays a huge role as the source of potentially outsized gains. A new business is fundamentally a speculative roll of the dice on an idea for a product or service that may or may not find favor. Fortunes can be made when such wagers are successful, as business history in capitalist-oriented societies clearly demonstrates. Stock market trading is also speculative and can be lucrative, especially when carried out with borrowed money. Neither of these activities qualifies as true investment, however, as the preservation of the capital employed is far from assured. Note that “speculation” plays an important role in our economy through the creation of new employment and wealth. It requires a different skill set than investment, however, as well as pluck and luck.
Traditionally, risk was thought of in terms of the possibility of permanent loss of capital; most individuals think of it that way still. Such losses are painful. Capital is irrecoverable, current and future consumption and perhaps a comfortable retirement are impaired. But when is a loss permanent, as opposed to merely a temporary setback? Such questions have always been part of the investment problem: the evaluation of the true value of a security, as opposed to its current price.
For several decades Wall Street and academia have attempted to quantify risk through the application of statistical methods in the analysis of asset price fluctuations, or “volatility.” According to this view, the higher the frequency and magnitude of price fluctuations, the greater the risk. We believe this theory is not supported by observation. In recent years, for example, the U.S. stock market as a whole has been characterized by unusually low volatility. Daily fluctuations of 2% or more, not uncommon in the past, seldom occur nowadays, and significant “corrections,” or 10%-20% declines, are almost things of legend. Advocates of the modern statistical theories, therefore, would have to argue that markets are less risky. Yet we look at markets that have been pushed by liquidity and driven by a lack of attractive alternatives, inflating valuations to rich levels (to records by some measures) that rival past peaks. Even the non-professional observer using common sense can see the signs of danger.
An interesting aspect of risk occurs when events continue to unfold smoothly, despite what is perceived to be clear signs of potential calamity. Exuberant markets can go on indefinitely with no ill effects. In a different sphere, since the world survived a cold war with no “mutually assured destruction,” it is tempting to think that our caution was unnecessary and too costly. However, just because catastrophe was averted it does not follow that there was no risk; decades later we learned how close the world came to “MAD.” In the markets, where only our money—not our lives—is at stake, we have seen time and again throughout our experience that when the music stops playing it is far too late to worry about preserving capital. You never know for sure when the band will pack up and go home.
In the investment sphere we believe that risk is growing, and it comes from a variety of sources. The rise of “passive” investing, with its insensitivity to valuation, promises to distort capital allocation in general. A related issue: the decline of traditional security analysis (and the analyst community on Wall Street) has resulted in decreased pressure on issuers to come clean with their accounts. Valuations are extended. Finally, the very fact that the markets have been rising for so long stores up danger as market participants become more relaxed about making commitments, even when many are aware that circumstances are less than favorable.
We favor the traditional view of risk as the possibility of permanent loss, which is less quantitative, perhaps, but more wedded to market realities. Given current market conditions, losses may not be permanent ultimately, but they could be painful and long lasting.
In a wonderful piece by Financial Times editor Lionel Barber, the author points out that lies, distortions and misleading statements have been used for devious purposes for millennia. What is new is technology, which, as Barber states, has “flattened the digital plain,” creating the “illusion that all content is equal.” This creates problems for public discourse, and democracy, especially at a time when journalists—the traditional gatekeepers of information flow—command less respect and influence among the chaos of the Internet.
In the world of finance, such “fake news” is familiar stuff. Where there is money, there are liars, and the history of Wall Street is full of colorful characters using various subterfuges to separate people from their money. Technology now plays a big role here, too; Madoff was able to create a plausible illusion of superior investment results through the creation of fake trading reports and account statements.
Most of the distortion that happens on Wall Street and in the corporate world is perfectly legal, if ethically questionable: accounting manipulation, for example, and giving positive slants to business developments or earnings “guidance.” The overall result of these behaviors, legal and otherwise, is a decline of trust and a web of regulations to reign in bad actors and enforce some transparency. In the media realm little can be done to regulate the purveyors of fake news, and the erosion of trust in public institutions continues. At least in finance, measures can be taken to discourage bad conduct.
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No guts, no glory, as they say on Wall Street, or, to use the accepted academic formula, the higher the risk, the greater the reward. Fake news or no, market returns this year have been quite real, and substantial. The S&P 500 index, the Dow Jones Industrials, and the Nasdaq returned between 14% and 20% year to date through September. One can quibble about the figures—technology has played an outsized role this year, for example—but they are respectable, and remarkable given the risks the world faces at this time, from Korea to political extremism. To borrow another expression popular within the financial community, the markets have definitely “climbed a wall of worry.”
Dennis Butler, MBA, CFA