Risk and Return Revisited
Risk and Return Revisited
Harry Markowitz, Nobel prize winner and creator of Modern Portfolio Theory, passed away on June 22. His work, dating back to the 1950’s, led to the Capital Asset Pricing Model, Efficient Market Hypothesis, and the $11 trillion world of passive investing known as index funds. He gave structure to portfolio management where none existed before, shifting risk management from the security level to the portfolio level. Since the early 70’s, business school students have been indoctrinated in the modern finance canon he inspired, including Modern Portfolio Theory’s original sin: defining risk as short-term price volatility.
Fast forward 50 years. A quarrel unfolds on social media between a quantitative equity fund manager and a private equity investor. The private equity investor, Mr. P, marketed his fund’s low volatility, and therefore superior “risk-adjusted” returns, to the investment community. The prices Mr. P used to calculate volatility were those derived from his own mark-to-model estimates of intrinsic value. The quantitative fund manager, Mr. Q, took umbrage. If you marked your portfolio to the market, he argues, your volatility would be much closer to mine.
Mr. Q is unequivocally correct. What Mr. P presented is not how the real world works. Mr. P is also correct, however, in believing that public market prices do not necessarily reflect intrinsic value. Mr. Q might not disagree. Thanks to Nobel prize winning economist Robert Shiller, we know public markets are more volatile than they would be if markets were informationally efficient.
None of that justifies Mr. P’s marketing his own calculations of price and therefore volatility. It’s incongruous to have referenced a short-term volatility statistic at all. It’s a hollow definition of risk for an asset class that commands a long-term commitment as equity markets do, public or private. Putting expected returns together with volatility was a marriage of convenience for Markowitz, a concept, wrote Daniel Crosby, that was “bastardized to serve a computational end.”
The danger in not calibrating the volatility in a portfolio to public prices, says Mr. Q, is in understating risk. Yes, it’s dangerous to understate risk. It’s equally dangerous to wrongly define it, likely misprice it, and gain false comfort in the process. Future volatility (and correlations) will feel no moral obligation to look like the past and might fail to do so when needed most. Yesterday’s short-term price variance will do nothing to accurately prophesize that 100-year storm, when correlations become the tail that wags the volatility dog.
Mr. P doesn’t have a monopoly on misleading statistics. Disciples of modern finance have long stretched to defend metrics that serve their own marketing programs. Mr. P’s prices may be make-believe but in pointing out the error Mr. Q draws attention to the hedge fund industry’s own use of the same flawed risk measure generally, and the mythical notion of risk-adjusted returns specifically. Try to take those risk-adjusted returns down to your child’s college to pay the tuition bill. Talk about your false profits.
What of the seemingly irrational need some investors have for entering a long-term commitment to prevent themselves from succumbing to myopic loss aversion? In the endeavor to understand markets, behavioral science is more than a test of faith; it’s the missing link. Mr. Q may optimize his utility like a rational economic agent; most market participants do not. The reality is that equity investor returns would benefit from friction in trading. The data is overwhelming in this regard. But strapping yourself to the mast of a ship like Odysseus trying to avoid the siren song of trading? I would envy the self-awareness.
Are future private equity returns driven lower by investors flooding the market in pursuit of lower volatility? Though the net effect will be the same, it’s just as likely dollars have been increasingly allocated to this asset class in pursuit of the higher historical returns. If not price volatility, then what definition of risk? Illiquidity is still a risk, one that does seem odd to pay for. Leverage adds risk as well. Neither is a good definition of investment risk. I’ll propose two alternative definitions: permanent loss of capital and failing to achieve long-term return objectives.
Permanent loss of capital happens because the investor is forced to sell at a loss to meet current cash needs. If foolish enough to invest money in the stock market that you might need in the next few years (no less the next few months), standard deviation is the risk metric for you. If you can strap yourself to the proverbial stock market mast for a dozen years or more, that equity index fund has always made you money, short-term variance be damned.
Failing to achieve return objectives gets short shrift as a risk factor in the academic world of modern finance, where total return is subordinate to risk-adjusted return. Nearly everything fund managers do to decrease price variance will cost investors total return in the long run, from hedges and market timing to excessive diversification and allocating to lower-returning strategies just because they are uncorrelated. It cannot be otherwise.
That leaves us with the Golden Rule of investing: given a time horizon, invest to maximize total long-term return. Replace mean-variance optimization (a false dilemma anyway) with return optimization. Buffet simplifies it further: “The investment shown…to be the cheapest is the one that the investor should purchase.” Everything else is commentary.
John Emrich is host of the Kick the Dogma podcast and a retired equity fund manager.