The following is an extract from an article in the most recent Allan Gray Quarterly Commentary published Dec 2014, in which the writer addresses the inherent risks of investing in stock markets in an attempt to dampen the irrational exuberance of investors.
“Efficient market theory holds that there is a direct relationship between risk and return: the higher the risk associated with an investment, the greater the return. This is intuitive: when we choose investments that we think are more risky, we naturally expect to be rewarded with higher returns.
Unfortunately, in the real world, this simplified relationship does not exist. We have imperfect information, so we are forced to deal with perceived risk and expected return. And at any level of perceived risk, there is a range of potential outcomes, as shown in graph below. By definition, this range widens as the risk increases, making it progressively more challenging to predict outcomes with any certainty. Your actual return could be far higher or far lower than your expectations. Even with perfect information and analysis, taking on greater risk does not guarantee greater future returns.” Wanita Isaacs (Allan Gray)
I am concerned that investors may have become complacent as global stock markets supported by unprecedented central bank policy action have rebounded from the global financial crisis of 2009.
Co-ordinated manipulation of cash / bond yields (financial repression) to historic low levels have forced risk averse investors to move out of their comfort zones by taking on more risk assets (equities) to simply achieve the same returns they would have by investing in traditional risk free assets of cash / bonds.
The obvious concern is that investors are now investing in assets inappropriate for their personal risk appetites. This is all fine and well while you have ultra-low volatility, but what happens when the volatility returns; notice I said when and not if. These investors are likely to pull the plug on their investment strategies, thus crystalizing their losses.
I am not trying to discourage investors from taking on more risk, in fact most investors err on the side of being overly cautious, but what I am saying is, make sure the investment risk budget is in line with your personal risk appetite (i.e. your ability to handle volatility) and most importantly your investment time horizon.
“If you don’t know yourself, the stock market is a very expensive place to find out”. Warren Buffett
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