Today, while perusing a favorite site of mine, Minyanville, I came across a great op-ed piece that touches on an idea of risk perversion that I very very poorly examined a few months back (I just reread it and stared blankly at the screen). A few months older and maybe wiser, this article helped me better drill down on the ideas in my head and I would like to comment on and add to his analysis.
The op-ed piece is basically an assault on the recent government bailouts and moral hazard surrounding fiscal and monetary involvement in the markets. He writes,
As a result of my values and life experiences, I chose conservative
personal finances. Due to my preference for security and prudence, I
forgo the opportunity for larger gains and windfalls in exchange for
the lower risk and security. It used to be that I could live with this
trade-off. However, the last decade (and last few years in particular)
have made this choice increasingly difficult. Not only have risky
investments been deliberately supported by government policy, but less
risky paths have been infected by overspill from the risk-taking
activities; worse yet, my very own government is treating me as a
sucker. I mean openly, which is kind of new.
This gets at the heart of the idea of risk perversion - a phenomena where investors accept misunderstood view of risk which spreads throughout the market and through processes such as reflexivity becomes dogma. A great example of this is "home prices always go up". This slowly infiltrated the real estate market over the past few decades and caused many of would-be renters to leverage themselves beyond their means and rationality in order to invest in an asset that they thought was risk free. In doing so, the massive shift of renters to buyers caused this assertion of risk to appear to be correct by many statistical measures over extended time periods - up until recently.
Extending this to the Modern Portfolio Theory definition of risk budgeting between the risk-free and the the risky asset leads to more interesting conclusions. The risk-free asset, usually defined by a Treasury Bill, is supposed to be, well free of investment risk. Since fixed income investment risk is made up primarily of purchasing power (inflation) risk, default risk, interest rate risk, and liquidity risk. Since T-Bills are highly liquid, usually held to maturity, and virtually default-free, this leaves us with only inflation risk. Inflation risk is a very sneaky risk, because it is not usually evaluated post-facto. Although CPI measures can be subtracted to get a real rate of return. An investor who invests $950 and receives $1000 a year later usually doesn't factor in the fact that his $1000 can only now buy $980 worth of goods and services, mainly because that is not what it is used for as the investment proceeds are reinvested and 2% inflation over one year is hardly noticeable. Although this should be and usually is considered before such an investment is made, it is usually not evaluated directly afterwards. It is usually years later, when inflation begins to compound that these effects are realized and evaluated. Additionally, under a normal yield curve environment, inflation should gradually push yields up therefore compensating the investor for inflation as he/she reinvests. Should inflation risk get out of control, risk-averse investors soon find themselves taking on no risk and taking a loss to do so - which is not a characteristics of a healthy economy and capital market.
The slutty stepdaughter of Modern Portfolio Theory is the Capital Asset Pricing Model (CAPM), which has been used and sometimes abused by almost everyone in Finance over the past quarter century. When choosing to diversify between the risk-free and risky asset, this formula gives an expected rate of return for an individual investment:
Expected Rate of Return = Risk Free Rate + Beta*(Expected Market Return - Risk Free Rate)
E(r) = R(f) + B*[R(m) - R(f)]
Let's assume that this risky asset is the S&P 500 SPDR (SPY), with a Beta of 1 the equation quickly reduces to what we would expect.
E(r) = R(m)
I mentioned earlier that under NORMAL conditions inflation risk on the risk-free-rate of return is not really evaluated, however a inverted yield curve and inflationary period where year over year inflation (as measured by CPI and PCE) has increased more than the risk free rate. The chart using CPI shows this to be a very recent and rare phenomena - occurring post-bubble from 2002 to mid 2005
and using PCE as inflation benchmark....
Well what does this all mean?
First, the obvious observation is that for a substantial period of time, the real risk free rate of return was actually negative. During this time period, the risky asset dramatically outperformed the risk-free asset as the market roared back from the post bubble collapse. This is important because a large pool of investors allocated to the risk-free asset experienced a relatively substantial negative real return over an extended time period. Up until 2003, any time that this phenomena existed or got close to existing it was immediately corrected. As the always appropriate George Dub once said, "Fool me once shame on me. Fool me twice shame on you." I add, "Fool me three times and I'm a fool."
Next we should look at how this all factors in to the CAPM model, substituting the risk free rate, with the factoring inflation into the expected market return and risk free rate
R(e) = R(f) - i+ B*[R(m) - i - R(f) + i] = R(f) - i + B*[R(m) - R(f)] = R(e) - i
Therefore as expected we can conclude that by adjusting the various input returns for inflation we get an expected return that is adjusted for inflation.
So, then we can conclude based on CAPM, adding inflation into the calculation does not fundamentally change anything, however the fact that the risk free rate of return is negative will affect how one allocates between the two portfolios.
A fundamental concept of CAPM is that an investor should be compensated based upon the time value of money and risk. The time value of money is represented by the first half of the expression, R(f), whereas risk is represented by the second half, B*[R(m) - R(f)]. If the real risk free rate is negative, the investor is not compensated for the time value of money, but rather PENALIZED for it, since he is not taking any risk. Therefore the rational investor will not allocate towards it unless of course he is being compensated even less for risk.
Whereas the time value portion of the equation is very straightforward and can be almost perfectly analyzed ante-facto, the risk portion is very difficult to analyze before investing. Forecasts must be made based for market return and assumptions for beta.
If an investor assumes that at the very least, he will be compensated more for allocating towards the risky portfolio and should be compensated at least at level equal to inflation risk for investing in the risky portfolio, thus substituting inflation, i, for R(m), the the second half of the equation changes to
-B*(R(fr)), where R(fr) is the real risk free rate
Then the new equation can be constructed where
R(e) = R(fr) - B*R(fr)
In a situation where the real risk free rate is negative, the equation is always maximized when the investor allocates away from the risk-free portfolio. Only when inflation expectations turn positive will an investor in this situation ever allocate different.
Another important feature of all of this is that if real risk free rates are negative both market risk as well as any types business or financial risks of the risky portfolio that are added to expected market returns above inflation are irrelevant. In any case he will choose the risky portfolio, if he believes both the risk free rate will remain negative and that risky returns will at least equal inflation.
Thus, the perversion of risk. Facing a negative return on the risk free asset, the investor is FORCED to either take a loss or take risk - sometimes much more than he or she would like or will get paid for. Although inflation risk is the same for both portfolios, it becomes much more "rational" to risk loss to make a gain then to accept loss with almost 100% certainty, thus inflation risk is proportionally much higher in the risk free portfolio than in the risky portfolio although it is the same in magnitude in both. In its crudest form, this may be the framework that has perpetuated much of the madness that many of us have griped about for a few years now. The relative risk free asset has been the one that doesn't take your money but gives you a shot at making money by taking risk - if that does not make sense then you are not alone.
The fact that investors would only need inflation to pass through earnings is what created a risk free asset from a risky asset. Although this has not happened throughout history, I hypothesize that a debt infused economic boom devoid of real wage growth and characterized by rampant consumption and the outsourcing of fixed labor costs would almost exclusively be inflationary and any earnings growth should be equal to inflation plus any operating gains or losses. If the credit fueled demand caused the price of Good A to increase almost 10% in the store and globalization and other factors only caused costs to increase 2%, the company selling widgets should grow its earnings by about 8% - add financial leverage to the situation and these earnings increase even more - offsetting any input cost inflation.
Essentially, this phenomena spawned what appeared to be a very profitable trade for many who picked up it. Inflation risk was priced differently in two very liquid markets. In the risk-free market taking on inflation risk generated a negative expected return, whereas in the risky market it generated an expected return that greater and presumably could be magnified proportional to market risk as well other underlying investment risk. Therefore the "astute investor" - and I use that term loosely - thought that they were simultaneously buying and selling inflation risk and capturing the spread - let's call it inflation risk arbitrage. Obviously this thought process wasn't so technical, but has simplified by many notable investors and journalists who recommend that equities are the only way or easiest way to keep up with inflation and nurtured by famous investors such as Joel Siegel, who claimed that over time stocks offer greater return for much less risk. The fact that many years passed where "safe" investors started to realize that they were losing money helped perpetuate such a trade and change the entire market's outlook on risk.
The reality of the situation is that the risk profiles have not changed. Inflation masked business risk and financial risk for risky investments as the special, global, credit driven, [insert whatever you want here] inflationary environment enabled companies to increase profit margins enough that any volatility in earnings, sales, or poor capital investment, went relatively unnoticed - which feeds into the idea that liquidity and volatility are polar opposites. As liquidity dried up, many investors in financial and consumer discretionary stocks were introduced to business and financial risk that they unknowingly or perhaps were "forced" to take on. This wiped away a few years inflation gains in only a few months. The fact that bailouts are now punishing those who did not realize this even complicates the situation further.
The probability distribution that describes business risk has a much higher kurtosis than that which describes inflation risk (bigger more infrequent observations). This enabled the risk it to lurk underneath unnoticed and unseen and create what seemed to be a risk free arbitrage. When receiving a fixed payment inflation risk is easily approached ante-facto and managed. When expecting to sell sometime in the future at a higher price, inflation risk is more or less embraced and hoped for. Investors who thought they were capturing some sort of spread (whether they
outwardly realized it in such technical terms or not) hoped to end up on the bright side of an inflation trade. It wasn't until they got
burned that they found out what they were really capturing was extra risk premium that was defined by infrequent and large (or severe) observations. This trade was able to carry on for quite some time as many conservative investors after one or two years of investing in T-Bills, woke up to the fact that they were losing money and prices going up everywhere.
To finish up touching upon the op-ed piece, the moral hazard of all these bailouts is not only that it encourages wild risks to be taken, but also does not allow for the pain and reflection that is associated with a loss and for the real reasons for that loss to be explored. Loose monetary and fiscal policy and too much credit in the system enabled a dangerous situation where risk-averse investors lost money to take no extra risk rather than lend money to earn a return. Poor oversight and suspect conflicts of interest enabled this to spiral into many years of perceived risk perversion and a damaged market psyche.
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