Ever wonder why an asset rising in price seems less risky, and if dropping seems more risky? Ted Lucas of Lattice Strategies (strategic partner of WhaleRock) explains how to avoid the trap. This piece is a follow-on to “Navigating Your Journey: Understanding Investment Risk,” by WhaleRock’s Rich Cavanagh.
Antti Ilmanen’s book, Expected Returns, has received rave reviews among the sophisticated investing cognoscenti. Larry Siegel, most recently director of research for the Ford Foundation, calls it in his endorsement on the back flap the “best book on investment management ever written.”
That must have felt nice.
Ilmanen’s important central premise is that understanding return expectations embedded in an asset is inextricably linked to understanding the risk of the asset. When asset valuations are very stretched after a sharp and/or long upward run, the future returns required to support the valuation approach impossibility, leaving the asset – be it an individual security, asset class or regional exposure – with very limited upside and significant downside vulnerability should investors reduce their expectations of future returns or fundamentals supporting those expected returns fail to materialize.
Conversely, for assets that are trashed and unloved, the future expected returns are likely quite low as implied by their compressed valuations. In this case, the reciprocal is true: there may be limited further downside in the asset, yet significant future upside should expectations be positively revised or fundamentals turn out less dismal than expected.
One of the key implications of this idea is that conventional price history-based risk measures may suggest the opposite about an asset’s relative risk level. For instance, an asset that has been trending upwards without being punctuated with periods of downside would appear to have lower realized volatility, which, in turn, would make its volatility-based risk measures such as value-at-risk appear relatively low as well. An asset that has recently suffered an erratic and sharp decline may appear quite Read More…