Economic theory teaches us that rational investors are risk-adverse. This is to say that, for any given level of expected return, an investor will choose the least risky assets in which to invest.
Like so much theory, economic theory suffers from assumptions that are absent in real life. For example, there is an assumption that risk can be measured, that expected return can be predicted, and that past returns, in fact, can be achieved over time. Last but not least, it teaches that investors are rational, while the evidence of history and crowd psychology suggests otherwise.
The classic risk-adverse investment is in United States Treasury securities. Because the Government can print whatever volume of money is necessary to honor its obligations, the ability of the Government to default on its debt is considered to be impossible.
At this time, short-term Treasury issues are yielding close to zero. Even a ten- year bond returns only about 2.5 percent per year. There is a general consensus that, at some point, inflation will rise and bond yields will have to move up in tandem. Thus, while a Government debt investment will negate the risk of not getting principal back, it will not provide protection against future inflation or interest rate increases.
A bit further up the risk curve is the stock market. While some investors have profited handsomely from the market’s performance over the past five years, others are still traumatized by the volatility witnessed before the last meltdown in 2008-09.
Volatility is a tricky subject. Investors in general do not like it; yet over time returns from volatile investments exceed those of less volatile ones. Thus, when markets decline, investors tend to sell out of volatile investments even when the funds are not needed, just to avoid the effects of volatility. Conversely, when markets soar, investors are attracted to investing in such markets, even though new money coming in buys less than earlier investments in the same.
The reason for this has less to do with any tenants of finance, and more to do with human nature. Most people desire predictability in their investments. For this reason, many investors acquired Certificates of Deposit back when they had higher returns, annuities, government debt and the like. The general idea was that even if one invested more conservatively, the conservative investor would win out over time. Sort of The Tortoise and the Hare kind of thinking.
The problem is that, just as being too aggressive an investor can carry a price, so can being too conservative. Returns that are a fraction of what is enjoyed by others can be tolerated, but not if one’s results trail inflation, especially after taxes, and not for long periods of time. Thus the conservative investor becomes an aggressive investor often at the wrong time (after other investors have made many times his or her returns) and for the wrong reason (everyone else is doing it and making extraordinary amounts of money). I will never forget watching during the late 1990s, as people who had invested conservatively for years cashed out of CDs to buy shares in internet mutual funds, none of which now exist. Such is the power of crowd psychology.
So what is the best disposition to have? Being contrarian has its moments. This is best defined by the quote of Warren Buffet, “being fearful when others are greedy, and greedy when others are fearful.” This is easy enough in theory. The problem is overcoming human nature to become fearful at market bottoms and greedy at market tops. Someone who has to have the adulation of the crowd has no business managing money for this very reason. One cannot stand aside from a crowd if one has a desire to be part of the same crowd. To be contrarian is not just to be different, but to be apart. From being apart comes objectivity, which is different from being different for the sake of being different. This is what Edmund Rostand meant in his play Cyrano de Bergerac, when his title character spoke of cultivating, “an eye to see things as they are.” And this is why there are so few true contrarian investors.
While being a contrarian does work best over time, it will not work all the time. No investment style does. However, other approaches either dismiss risk until its costs are unavoidable, or avoid risk until its attendant returns are out of reach. Contrarians will be early leaving a party, or the first to propose, however heretically, that the time to get back in has come. They are not seen at the tops or at the bottoms. No investment style is present at both extremes all the time. But they do try to capture the upside and downside, which is what above-average investment returns, adjusted for risk, is about.
Those who are retired face special issues in this regard. Without salary income, risk becomes something one avoids, lest principal not be maintained. While every person’s comfort level is different, it is insightful that most people sold investments at the last market bottom with no need for the funds and no idea what to invest in as an alternative. The desire to maintain cash as a safe harbor exerted a terrific attraction to many people. Even those who managed to get out at the top, in many cases failed to get
back in at the bottom. Cash can be comforting, but not if one spends principal in lieu of returns on investment. That is like burning furniture to keep warm.
The economy is showing signs of vigor after the winter doldrums. Auto sales are estimated to be up ten percent in April, and housing construction is gaining pace.
Of special note is how the problems in the rest of the world, specifically Ukraine and Russia, have had so little impact on the US economy thus far. While Russia is the world’s largest energy exporter, the growth of the domestic oil and gas industry has insulated us from much of the disruption in that part of the world.
Evidence exists of some stirring of interest rates, but nothing so large as to attract economic attention. Lending is beginning to accelerate, although lending standards are still much higher than before the last recession. This is especially true in housing, as the former standard of twenty percent down or mortgage insurance for the balance has again become the norm.
Wage pressures are finally becoming manifest in certain parts of the country and certain industries. Subcontractors for housing construction are in demand in the dozen or so cities that are experiencing the bulk of the housing rebound. Oil field workers in the Dakotas have been in demand for years. Abandoned factories are being snapped up by firms desiring to bring back production to the US from abroad.
How inflationary these trends become depends on how fast the workforce can be retrained to supply the requisite skills and the willingness of people to move where jobs are. Perhaps Government policy can be redirected in this direction, but signs of this are not encouraging.
The Stock Market
After a bit of a correction in the technology area that still has not run its course, stocks seem to be finding firmer footing going forward. Low interest rates provide an absence of competition, as well as fuel for the buyers willing to leverage up their positions.
So far, first quarter profit disappointments have been mostly weather-related. If that is the case, there should be some earnings acceleration in the second half. Stock prices of certain industries should follow.
Warren M. Barnett, CFA April 30, 2014