Roger on risk

Roger on risk

…why should an investor, keen to see their wealth increase materially over the next ten years, pay any attention to the All Ords?

Many investors focus on returns, and during bull markets they make back most of what they lost in the periods where prices fell and a little more. But in most investors’ experiences, that is all. Another perspective, and one we employ at Montgomery, is to focus first on risk. There are a number of ways to do this but the most elegant, if not the simplest, is to think first about the probability or possibility of permanent loss of capital.

‘Permanent loss of capital’ can itself be considered in two lights. The first is a capital loss and the second is a loss of purchasing power. Serious long-term investors, if they are focused on risk, think naturally about the loss of capital but less about the impact of inflation on their returns and ultimately their clients’ and their own lifestyles.

The stock market of course – and the many academics whose fascination with it translates into research that seeks to further our understanding of money, markets and ourselves – spend an inordinate amount of time thinking about risk, and while there are emerging new ideas about risk, the biggest contribution from academia has hitherto been the measure of risk known as beta.

Wildly but unjustifiably popular, beta is a measure of volatility of a security about its benchmark. An asset with a beta of 1 indicates the price of the asset moves in the same direction as the benchmark and about the same amount. A beta of more than one means it tends to move in the same direction but more than the movement of the benchmark.

The higher the volatility of a stock, for example, the higher its beta and therefore its risk. This initially seems logical. If you are a superannuate you would like to minimize beta. Who wouldn’t want to achieve 15 per cent per annum smoothly?

But as Abraham Maslow stated in 1966, “to a man with a hammer every problem looks like a nail” and beta is now the universal benchmark measure for risk.

Beta however has several drawbacks. First of course is that while there are universally accepted periods over time to measure volatility, in reality there is no right period. Perhaps more interestingly though is the idea that a stock whose price moves about more than a benchmark is more risky. Such an argument presupposes that the benchmark is some omnipotent being or at least some purveyor of desirability.

The All Ordinaries index is full of rubbish companies that generate poor returns for their owners and have added no value over a decade. In turn, their weightings in the index are large by virtue only of the fact that they are big businesses. They aren’t good businesses. So why should an investor, keen to see their wealth increase materially over the next ten years, pay any attention to the All Ords? Over the long run, you should be materially better off buying a suite of companies whose quality is far superior to those that dominate the All Ordinaries, irrespective of whether their share prices diverge significantly from that index. Indeed you should wish that they do!

Furthermore, the selection of a benchmark has become conventional through standardization but it has become no less arbitrary. We might for example measure the beta of gold against the S&P500 and discover that the beta is low or even negative, and conclude that by putting gold into a portfolio we might reduce risk. This is plainly nonsense.

Or think about cash for a moment. Earlier this year I transferred some term deposits into US dollars. Putting aside the subsequent decline in the Australian dollar, the yield I am receiving on my US dollar term deposit is virtually nil. So is the beta of cash. With a beta of zero, cash might be seen to be uncorrelated and low risk, but given there is a 100% certainty of me losing purchasing power from being invested in such a term deposit for any meaningful length of time, beta is virtually useless as a measure of my real risk.

So this brings us back to our own ideas about risk and whether the market, with its declining volatility and absence of reasonably priced opportunities is actually more or less risky.

From our perspective now is the time to be very attuned to risk because when there are few high quality shares trading cheaply, the risk of capital loss as well as the loss of purchasing power is significantly higher.

Roger Montgomery is the CIO of Montgomery Investment Management. Click here to find out about investing in The Montgomery Fund.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.