1917 and 2017
As much of the world salivates over proliferating alleged links between the Russian administration and President Trump’s campaign team, we focus on a different, but for investors no less important, link between Russia, the US and stock markets.
100 years ago, a convulsing, disenfranchised working class overthrew the gilded elite in Russia. The St Petersburg stock exchange, only recently reopened following the First World War, simply ceased to exist. Investors who had not got their capital out of the country in time lost it all. One year ago last Wednesday, a property magnate surfed a wave of popular discontent all the way to the highest office in the United States. Predictions of economic and capital market chaos were soon confounded however, with US stock markets returning an amazing 24% in dollar terms since that day.
Risk and return
We can so far happily argue that we were right to count on a mix of economic self-interest and constitutional sludge to blunt much of President Trump’s proposed agenda. This allowed us to focus instead on the economic forces already in motion, which we deemed sufficiently robust for us to continue to lean portfolios towards stocks in general and US companies in particular. However, the reality is that the risk that we took (and continue to take) in this stance was never fully quantifiable in the way that the financial services industry (and its clients) longs for.
The disappearance of the St Petersburg stock exchange may similarly serve to illustrate that the relationship between risk and return is an unfaithful one – how could it not be? As a predecessor has pointed out1 – how can it be a risk if you know you are going to get paid?
When we talk about risk, we usually mean the range of potential future outcomes, i.e. the threat to our expected return. Our best means of approximating the magnitude of this threat is by analysing what has happened in the past – whilst short-term trends come and go, long-term risk metrics are reasonably stable. That is to say, asset classes with wide spreads of historical outcomes usually go on to reoffend.
The key point is that it is the spread of historical outcomes that informs our formulation of future risk – not the absolute actual return level. Safe-haven bonds have, for the past thirty years, delivered equity-like levels of return, but the experience has been one of a steady escalator rather than a roller-coaster. It would be a mistake to infer from this that bonds and equities will have similar spreads of outcomes in the future – this would be to confuse the average of a distribution with its range.
We therefore believe that equities will continue to offer investors more of a thrill ride than bonds, and that in the long term they will also provide superior returns. But this may not be because the risk must be compensated for in some kind of karmic fashion; rather because the very same characteristics that imbue stocks with high growth potential also expose them to high volatility. To put it another way, both ice creams and sandals are popular when the sun shines, but ice creams do not cause sandals, nor vice versa.
How should an investor position their portfolio when faced with such an unreliable link between expected risk and return? Whilst it makes some sense to project a strong correlation between the two, history has shown it to be far from perfect. To address this uncertainty, we recommend asset allocations sufficiently robust to withstand unlikely eventualities.
This can be achieved by simulating a multitude of possible futures, each assuming that the risks we have witnessed in each asset class persist, as do the correlations between them – resulting in paths with similar shapes but different destinations across each scenario. When it comes to finding an asset allocation that will thrive under all environments, simulated booms and busts temper each other. Only the diversified portfolio survives.
A concentrated position in any particular asset class or investment can bring with it the potential for exciting returns – but also the threat of disaster, as the differing fortunes of the St Petersburg and New York stock exchanges attest to. Prudent asset allocation should resist the lure of betting the house on the tempestuous relationship between risk and return, and instead diversify across a battery of potential return engines. By integrating the lessons of history into our simulations of many possible futures, we recommend asset allocations to our clients that do just this.
1 Making sense of markets – An investor’s guide to profiting amidst the gloom – Kevin Gardiner 2015