Barnett and Company

How Avoiding Risk Can Create Risk: A Primer on False Risk Avoidance

Students of finance become acquainted with what is taught to be the “risk-free rate.” This is the return that can be obtained by investing in securities of the United States Treasury. Usually, the five-or ten-year treasury yield is counted as the benchmark rate, with potential returns taken as some increment of this rate.

What makes the treasury rate chosen risk-free is the assumption that the US Treasury can never default on its obligations. Since the government prints money, there is the potential for it to simply print more as their bonds become due. So long as Treasury bonds are accepted and interest rates stay stable, everyone is fine.

Since the first of the year, everything has not been fine. The ten-year Treasury yields have gone up only about 7/10 of a percent, but this was enough to cause the treasury bond to decline over 6.9 percent in value. The longer 30-year bond went down over 16.3 percent in the same time frame. While people who should know better remind us that the bonds will be worth face value at maturity, inflation ensures that the nominal worth at that time will not buy what it did when the bonds were issued.

Thus, avoiding the risk of default creates a risk of depreciation of wealth- a case study in how avoiding one risk creates another. Investors, especially as they get older, crave stability. In doing so, they sometimes make the fatal mistake of assuming that the volatility of prices is the same as risk. From this mistake, a premium is paid for assets that do not fluctuate in value. Usually, an asset does not fluctuate in value because it cannot be easily priced or sold. Some investors prefer the ownership of a non-traded partnership interest, even when publicly traded real estate offers more liquidity (ease of sale).

Most of the investing public considers the stock market to be the epitome of risk, given how much it fluctuates in value. As Peter Lynch, one of the early success stories of investing in the past 40 years, pointed out, the market goes down 20 percent or more at least one year out of three and two years out of five. In spite of this, stocks have a compounded annual return in excess of the categories of cash, bonds, or inflation.

Part of the success of stocks at beating other asset classes is that of the potential for rising dividends. As inflation increases sales and profits, often dividends are increased as well. The income from bonds is fixed, and most of the time, cash returns less than the inflation rate, especially if taxes are deducted.

The bond market has done well for almost 41 years. After Paul Volcker raised the yields on US Treasury bonds to 15 percent in 1980, interest rates have trended down to the level of close to zero late last year. Higher rates sustained the losses by bonds since. It is safe to say that the long decline in interest rates is over, and as yields increase, bond prices of longer-dated issues will continue to decline.

As we enter this new era of rising prices and interest rates, it would seem that assets that retain their value and/or increase their payouts would become ascendant. They will not walk a straight line, but they have a better chance of maintaining purchasing power than investments that get run over by higher rates of interest.

All this puts the risk-averse investor in an awkward position. They can either accept volatility and ride it out or seek investments that are not volatile and hope they maintain their purchasing power. Risk-aversion is almost a universal human trait. The problem is that, sometimes, aversion can carry as much cost as risk, if not more so.

Even in stocks, risk can be measured best after the fact. In general, the less a stock has in terms of a dividend, and the higher its price relative to its earnings, the greater the potential for gain and risk of loss. In terms of the overall market, data would tend to support the idea that stocks, in general, are generously valued. The problem is, no one knows how long this can last.

The Economy

The signing of the $1.9 trillion stimulus bill seemed to have thrown a switch on the US economy. Forecasts now call for accelerating economic growth for the balance of the year. Fourth-quarter numbers are for as much as a 6-8 percent gain year over year.

While revenues are expected to be up across the board, the cost of borrowing to stay afloat will hit some companies hard. There are some firms that were forced to sell additional stock to keep their doors open.
They will find earnings progress especially painful, depending on the number of additional shares sold.

Interest Rates

Interest rates, which have gone up since the first of the year, will go up more. The increase is the first of any size in the memory of many investors and has been an unwelcome jolt on the stock market.

Many investors in the stock market are not there by their own choosing, but because returns on cash and Certificates of Deposit are so low. As interest rates move to be over two percent for the ten-year treasury yield, look for money to move back into short-term cash investment from stocks. Also, look for the spread between non-investment debt and investment-grade to widen. Finally, muni debt at some point will also be impacted by the rise, although talk of higher taxes somewhat curtails the adverse impact for this category.

Inflation

Inflation predictions are for sharply higher rates. The debate seems to be whether the increase in the inflation rate will be temporary or ongoing. At this time, the predicted tightness in the labor market would argue for ongoing. This will change the complexion of investing going forward.

The Stock Market

Stocks have had quite the roller coaster ride to date. The Dow-Jones average is up 6.7 percent, while the Standard and Poors 500 is up 4.6 percent. The index for the over-the-counter market, the NASDAQ, is up only 3.4 percent, reflecting its technology dominance, while the Russell 2000 index, which has more small and fewer technology companies, is up 14.6 percent.

Going forward, there is a high expectation that smaller stocks will do well with the stimulus and stronger economy. Should this not be the case, a reaction will be swift.

A Note from the Founder

I have been informed that certain members of the firm will be leaving shortly to start their own venture. It has been described to me as focusing on financial planning and exchange trader products.

You will be no doubt notified of this decision in short order. As of now, your contract is for the services of Barnett & Company. While we welcome your patronage, this is your money. If you decide to transition to the new firm, you will need to fill out paperwork for that purpose. If you do not fill out such forms, your investments will stay with your current provider managed by us.

Please call me or Yvonne Hobbs should you have any questions. 423-756-0125.

Warren M. Barnett, CFA
March 22, 2021

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