Long Term Risk
Don't power up your firm's risk model if you are worrying about your own investments.
FEB 3, 2022
The market risks that matter for you and me are not the same risks that matter for a bank or a hedge fund. And, given that risk management has been designed around banks and hedge funds, it should not be surprising that we are not well armed in our approach to risk management. So don’t power up your firm’s risk model if you are worrying about your own investments.
A case in point: What are the risks that are material when we are looking out over our lifecycle, concerned about what our investments will look like twenty or thirty years, for some of us maybe even fifty years, into the future. There is a lot to consider here, but as we look out at the prospect for a possible market downturn, here are two points to consider.
First, over the very long term markets grow at a remarkably steady rate. The chart shows S&P 500 prices post-WWII in log scale, so we get a sense of the returns. It is pretty much a straight line. The average annual return is just under 8 percent. You can go back into the 1800,s and you will still see the same steady, linear growth, but with a slope closer to 7 percent. This is why pension funds are OK using actuarial rates for their asset-liability management.
The standard approach to risk modeling totally misses this. There, risk is assumed to grow with the square root of time. So whatever risk you see over the shorter term just gets worse and worse the further out you go.
Second, you can still have big problems even with a longer time horizon. Because sometimes one market event layers on another. Or a better way to think of it is that the market is made more vulnerable from one event, creating susceptibility to further events. The two highlighted periods are instances of this, a piling on of one market woes after another, creating what I have called lost decades for the U.S. market. This is referencing the term used for the Japanese equity market post-1990. That of course ended up being a lot more than a decade, but so it has been for periods in the U.S.
If you were looking at your portfolio in 1983, you would discover it was pretty much at the same place it was in 1968. The same thing for 2014; it would be in the same place as in 2000. So well over a decade of lost growth. And being flat for ten or fifteen years is not really being flat if you have expectations of 7 to 8 percent growth — expectations that seem reasonable enough given the very long-term trend. You will end the “lost decade” down over fifty percent from expectations.
This is also missed by standard methods. There is no mechanism that incorporates the market reality of these clustered events — which are by analogy, but not analytically, a longer-term version of the volatility clustering we see in the market in the day-to-day view, also missed with standard methods.
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CO-FOUNDER AND HEAD OF RISK
Rick Bookstaber has held chief risk officer roles at major institutions, most recently the pension and endowment of the University of California. He holds a Ph.D. from MIT.