Perhaps I need to take market risk more seriously

He let his fingers wander idly over the keyboard. And, when he opened his eyes, his screed had turned into beautiful flowing sentences.

“Eureka!” Jayesh shouted.

His wild and unconstrained enthusiasm for what he had achieved was no longer bounded by reality. His mind began to race and there was a manic glitter in his eyes.

He knew what he needed – an infinite army of monkeys to complete his masterful work of fiction.

Ok that’s a ridiculous idea. But it describes how I feel about stock market behaviour and some of its investors.

Let me explain. But enough monkeying around – I’m going to use rednecks in this example.

Pay attention!

If there were an infinite number of rednecks riding in an infinite number of pickup trucks, who fired an infinite number of shotgun rounds at an infinite number of road signs, they will eventually produce the complete works of Shakespeare in braille.

This is a highly improbable event, but it’s still possible.

That’s why in The Hitchhiker’s Guide to the Galaxy Douglas Adams wrote about a wondrous invention called the Infinite Improbability Drive. This fictional innovation allowed a blue whale to question the meaning of life while plunging to its death, while an infinite number of monkeys produced a copy of Hamlet.

However, anyone familiar with the stock market knows that the improbable happens quite frequently even without an Infinite Improbability Drive.

This is because when we say “improbable” we are making some terrible assumptions.

This is all thanks to Victorian statistician Francis Galton, who in 1877 presented evidence of something called normal distribution. Do you recall a picture like this below from school?

(Sam Swift, “What’s normal (or top 5%) for a CrossFit athlete?”)

Mr Galton took anatomical measurements from a large portion of the Victorian population. He was searching for traits of hereditary genius. Although he failed, he did demonstrate the beauty of normal distribution found in nature. He also gave us the concept of correlation and widely promoted the theory of regression towards the mean.

We’ve used normal distribution to observe risk in financial markets ever since. There’s just one problem – it doesn’t really work.

Capital markets are influenced by human emotions and cognitive biases, which are very different from the forces of nature. Extremely rare events happen far more frequently.

In the past 50 years, we’ve had nine major stock market crashes. This amounts to a crisis on average every six to seven years.

The problem is that the components of financial markets are not independent, which messes up the rarity of these events. When emotions are running high, everything becomes correlated.

This is why I think it’s a good time to think about where we are today.

Let’s see – global stock markets have continued to rise with extremely low levels of volatility. Indices are also at record high levels. The experts say it’s thanks to almost ten years of quantitative easing from central banks and ultra-low interest rates. This has apparently, inflated everything – stocks, bonds and real estate.

However, the US Federal Reserve has now announced it will end quantitative easing. It’s also strongly indicated another interest rate rise before year-end.

So what should an investor do?

“Don’t put all your eggs in one basket”, my father told me as a student.

It’s common knowledge and been endorsed by the academic community. Modern financial theory uses it as a foundation and explains that any risk that’s unique to a company can be diversified away. The risk that remains in the portfolio is market risk. And, the degree of exposure to this market risk is called beta.

Once you’ve diversified, you can adjust beta to a level you’re comfortable with, depending on your risk-return profile.

Diversification is important, but managing market risk is not that simple.

We have traditionally used volatility as our measure of risk. But it doesn’t really work very well. Let me explain with an example.

12 years ago, there was a terrorist attack on the London Underground. It became known as 7/7 because it happened on 7 July 2005.

I remember travelling back home late on a Friday night, a few months afterwards. It was quieter than usually. Studies in fact show that there was a 12.8 percent decrease in Tube passengers in the week that followed. The impact on the weekend was even larger – a 32 percent decline.

Despite peoples’ fears of travelling, statistically, it would have been just as safe to have travelled before the terrorist attack. There was no sudden increase in risk after if it happened. The unknown risk just became a known risk.

It’s the same with stock markets before a correction. If you look at volatility as a measure of risk, then your investments only become risky after the downturn has occurred. In reality the risk was probably greater, prior to the correction.

The nature of beta also changes with the mood of the market. Stocks that were once low beta become very responsive to the sudden bout of volatility. Everything becomes correlated and everything falls because investors are scared.

There’s strategy to protect yourself though – make sure you understand what you’ve invested in. If you passively buy the index, all you’re doing is making a bet on beta, and the odds are not great right now with such high market valuations.

What many investors forget is that the current market price does not necessarily equate with the company’s fundamental worth.

If a company is fairly priced based on its fundamentals, then this provides a cushion of protection in a stock market crash. If you purchase the stock after the indiscriminate sell-off, then you’re getting it for less than its fundamental worth.

These types of stocks will often bounce back after the crisis, just as quickly as they fell. In the long run, enduring fundamentals will eventually be recognised by the market as they continue to grow. But you’ll only see this if you’re patient.

Of course there’s nothing wrong in hiring an expert, or a portfolio manager. But, you need to understand what they’re doing.

In Burton Malkiel’s bestseller “A Random Walk Down Wall Street” he claimed that “a blindfolded monkey throwing darts at a newspaper’s financial pages, could select a portfolio that would do just as well as one carefully selected by experts”.

And he’s right!

Studies that simulated up to 10 million dart throwing monkeys, showed that the majority outperformed the index, while most portfolio managers underperformed.

It works because any bias to capitalisation is removed through random selection. And most indices like the S&P 500 are cap-weighted – they’re overweight the past winners and underweight the future performers. Many portfolio managers underperform because they lack conviction and find it easier to hug the index, while charging a fee.

You could invest in an index constructed differently: there are risk-parity and minimum variance approaches; there’s fundamental indexing that’s based on a company’s cash flows, profits, dividends and sales; and there are factor indices whose weights are based on value, growth, momentum and low volatility. Arguably these can be great screens.

However, you will still be exposed to another form of beta that needs monitoring. Therefore, you need to still understand the companies you invest in.

So what is the best forward-looking way to protect yourself against the next correction? I strongly believe you need try to understand the company’s fundamentals. This is tricky if you’re invested in an index. But if you don’t, you’re not really taking market risk seriously.