Thinking About Risk
How do you think about risk? Last year, the Canadian Investment Regulatory Organization (CIRO) adopted a two-pronged test for retail investors. The tests are risk tolerance (how much loss can you tolerate psychologically) and risk capacity (how much loss can you financially withstand). When asked to explain how these tests might be applied, regulators look at their shoes and offer banal platitudes to the firms expected to enforce them..
Many people may have reasonable definitions and tests for both these metrics, but neither one offers a clear objective measurement that can be applied across the board for all investors at all firms. In other words, standards are whatever each firm says they are and could vary wildly from one firm to the next. Thus, these two crucial tests are all but meaningless, since generally-accepted measuring sticks don’t exist.
Part of the problem is that certain products are rated on a consistent basis, while others, as well as individual securities, are not. For instance, mutual funds and Exchange-Traded Funds (ETFs) are offered via prospectus which carries a risk rating consistent across firms. Individual securities, however, can be rated differently at different firms. While nothing is ever certain, it is generally agreed that products holding 30 or more securities in a single basket offer more diversification and are less risky than the individual components of that basket.
Let’s not forget that the approximately 25% return in the S&P 500 in 2023 came because of a two-tiered market. The so-called “magnificent seven” stocks (Alphabet (formerly Google), Meta (formerly Facebook), Apple, Netflix, Nvidia, Tesla, Amazon) accounted for about two-thirds of the total gain, while the remaining 493 stocks accounted for the final third. The overall market is deemed to be a medium-risk offering. It stands to reason that many stocks used to compose the index are seen as riskier if purchased individually. The components of the market that explain most of the return also explain most of the risk, since risk and return are related. Those investments that go up most quickly are the same ones that could drop most quickly.
There are five categories of risk: low, low to medium, medium, medium to high, and high. Clients need to allocate percentages to each of them, and advisors and their firms need to stay within those guardrails. I found that five of the magnificent seven are rated as medium at my firm while the other two are medium to high. None of those stocks are rated as high risk. Once again, different people have different tests that might be applied. I don’t know how other firms rate these securities, but suspect the ratings are similar across the industry. The most likely methodology would involve an “equity waterfall” provided by a risk management software company where various metrics are applied, and risks are assigned. The metrics include price, market capitalization, relative turnover, midpoint price and yield tests.
These tests, in my view, often lead to ratings where large and growing companies are not flagged as risky. That lack of risk management and proper security assessment is madness, in my view.
One of the most widely accepted metrics is the price-earnings (P/E) ratio of a stock or stock market. Entering 2024, the P/E ratio for the S&P 500 sat at just under 26. Any stock with a P/E ratio over 26 might be deemed expensive (i.e., risky) relative to the market, and any stock with a P/E ratio under 26 might be cheap relative to the market. For context, the P/E ratio for the S&P 500 has historically hovered below 20, so a P/E ratio of 26 is already objectively more than 30% more expensive than the historical average. Expensive stocks are risky because when the price reverts to the long-term average, those that rise the most are also the ones likely to fall the furthest.
To me, any security that has either gained or lost 40% over 365 days or has a P/E ratio of over 40 should be rated as at least medium to high risk. Any security that has gained or lost more than 50% over 365 days or has a P/E ratio over 50 should be rated as high risk with no exceptions.
Next, let’s look at Robert Shiller's Cyclically Adjusted Price-Earnings (CAPE) ratio, which currently stands at just under 32. For perspective, it hovered around 30 when the stock market crashed in 1929. As of the first week of 2024, the P/E ratios for the magnificent seven rounded to the nearest whole number are:
Alphabet 27
Meta 30
Apple 30
Netflix 50
Nvidia 63
Tesla 77
Amazon 78
The arithmetic average of a typical magnificent seven-stock P/E ratio is one that trades at nearly 51 times earnings which is about three times higher than the historical P/E ratio for the market as a whole. That's another way of saying the magnificent seven are, on average, about three times as risky as the market has been historically. Despite this, five of the seven stocks are rated as medium risk (i.e., the same as the market as a whole) while two (Nvidia and Amazon) are rated as medium to high. That's an objective reading of three times the risk with a mostly identical risk rating!
I worry about industry Bullshift. Bullshift is a word I concocted to explain how the financial services industry keeps people feeling bullish by shifting their attention to optimistic narratives that may have little basis in reality. Minimizing the risk an investor might take is part of it. Everyone wants to make money, and as long as the bulls are running, people tend to suspend their disbelief and continue buying on the expectation markets will continue to rise. That's sometimes called the “greater fool theory”.
Whereas traditional theory would say buy low, sell high, the greater fool theory will say it doesn't matter if you buy high if you’re confident you can sell even higher. It should be obvious that a “buy high, sell higher” approach is riskier than the traditional approach.
I cannot help but feel a sense of foreboding when I see commentators with a straight face suggesting we can have both significant rate cuts and a soft landing. In reality, we will all be left with a stark choice; keep rates higher for longer in order to keep inflation under control, or risk inflation while allowing for multiple and/or significant rate cuts to stave off what would otherwise be a debilitating economic and market downturn.
The idea of navigating the economy to a soft landing while massively cutting rates and simultaneously keeping inflation in check with strong employment numbers is almost certainly a pipe dream. But this narrative is promoted by certain segments of the industry that want to keep investors happy and docile rather than worried and thinking critically. In short, optimism is good for business. I’m not opposed to it in principle. It's just that I prefer realism. Here is some more perspective to chew on in this expensive market that is fraught with potential minefields:
In the five-week drop in February and March of 2020, the NASDAQ index fell 38%. Does that seem risky to you? How does it dovetail with your risk tolerance?
More recently, on April 29, 2022, Amazon stock experienced a one-day drop of 14%. Does that seem risky to you? How does it dovetail with your risk tolerance?
Going back to semi-recent history, (remember that recency bias causes people to become complacent as past white-knuckle experiences fade from memory) in the period from February of 2000 to August of 2009—that spans nine years and seven months— the S&P 500 saw a peak to trough drop of 54%. Within that window, the global financial crisis of 2007 to 2009 saw the S&P 500 drop 56.8%. Does that seem risky to you? How does it dovetail with both your risk capacity and tolerance?
How can a stock like Tesla which trades at 77 times earnings and more than doubled in value in 2023 be considered a medium-risk proposition? In the late 1980s, the Japanese large-cap market (the Nikkei 225) was trading at such a multiple. It was only in 2024 – more than a third of a century later – that the Nikkei hit a new high. For those of you who claim to have a long-time horizon, how much time do you have? Do you think many people have the capacity to wait that long to regain their original investment? I call Bullshift.
I have seen New Client Application Forms suggesting that the longest timeframe to recoup one’s money is “more than three years.” In truth, virtually any portfolio, and certainly any balanced one, often needs longer to reclaim previous highs. In other words, unless every client opts for the maximum possible time horizon to recover, investors, advisors and advisor firms are all guilty of overstating risk tolerance and risk capacity. Bear markets haven’t been eradicated.
I have been expecting both a bear market and a recession for over a year now, and am convinced that whenever it happens, people won’t be ready and will claim that they were groomed into taking more risk than they really wanted or expected. They will only be partly correct. Mirrors will be needed, too. If clients end up selling because of a major selloff, their advisors will be held accountable for their role, as well. Was the recommended portfolio too risky for the client, or did the advisor fail in their oft-stated role of a behavioural coach? It seems one of those explanations must be true. Which alibi will advisors choose? My guess is that it will have to be the latter since the former might have legal consequences. Either way, it seems as though the industry will have some blood on its hands, and other stakeholders (regulators, product manufacturers and product distributors) will likely try to blame advisors.
In conclusion, there is little doubt we all have a daunting task in properly codifying and identifying sources of risk. Advisors are the ham in the sandwich. They are merely constructing portfolios based on unreasonably optimistic risk ratings set out by the industry. In this instance, “optimistic” means “unwilling to properly rate risky investments as such”.
To make matters worse, risk tolerance and risk capacity are heavily biased in favour of recent experiences. Stated differently, recency bias means that if markets have been going up lately, you are inclined to take more risk than you might otherwise because you were lulled into thinking the recent past is a prologue to what lies ahead. If something bad happens, many are unlikely to have “seen it coming” simply because they haven’t experienced anything similar recently.
Please revisit your risk profile and associated portfolio holdings immediately. My guess is most people reading this are taking more risk than they want… because they are taking more risk than they realize… because the industry makes more money when investors have a “risk on” mindset. If things don’t work out, regulators, manufacturers and distributors can always blame advisors before they look in the mirror.
John De Goey is a Portfolio Manager with Designed Securities and the author of Bullshift – How Optimism Bias Threatens Your Finances. The opinions expressed are those of Mr. De Goey and may not be shared by Designed.