Wall Street Exposed (Part 4): You’ve Been Lied to About Risk

July 19, 2012

Ask a Wall Street practitioner to define stock market or equity risk and watch him squirm to come up with an intelligible answer. The simple truth is that most financial advisors and analysts have no idea how to even define risk. If you get any answer at all it will probably be a ratio such as Sharpe or terms talking about volatility, standard deviation and maximum portfolio drawdown. But is this really risk? Does the volatility of your portfolio or even the share prices truly equate to risk? Even if this were true, does the advisor have the ability to forecast this?

A Bad Definition of Future Risk

How many times have you read the fine print that states past performance is no guarantee of future gain? Many financial advisors will scoff at the idea of backtesting* the market as they feel these will only tell you how things ‘would have turned out’ and is not realistic for investing in the now. You can’t drive a car by looking out the rear-view mirror…right?

*Backtesting is where you take an investing concept or strategy and test it on historical data to see how profitable it could have been. Backtesting done improperly can dangerously provide investing over-confidence.

So why do they not tell you that all their fancy Sharpe or related risk-adjusted ratio is simply a rear-view mirror explanation of past risk? What they are telling you is this:

  • “Looking at this chart I can see that the stock went up pretty far. And looking at the volatility it also went up fairly smoothly compared to the magnitude of the past gain. This is a low risk stock for future investing.”

Whoa…hold on just a second…did I hear that correctly? Anyone could look at 100 charts and quickly pick out the ones that went up fast and say these would have been good investments. But this is almost worthless unless you are planning on building a time machine and investing in the past. Actually, there is a slight advantage to investing in past winners in a practice called momentum investing, but I highly doubt your advisor is recommending that you flip mutual funds every few months as this would incur large fees. But the financial expert doesn’t stop there…he dresses the historical chart up with glasses and a calculator and makes it look some prophetic tool that can forecast your future risk and reward. But those fancy ratios are simply old photographs full of missed opportunity.

  • Think of this for a moment…last year stock ABC rose each and every day by 10% and now it is ridiculously valued.  For every dollar of assets the company has the share price reflects $100,000. Yet, this will have an incredible low-risk ratio since it traded upwards without any downward volatility. Does this seem like a low-risk investment to you? And a defensive stock with unwavering earnings that gets hammered in a bear market that is now trading at half its book value, with an earnings yield of 20% and a dividend yield of 15%… is considered to be infinitely more risky by the ‘risk-adjusted return ratio’. With this investment that has the fundamentals like the Rock of Gibraltar, do you think buying it carries hundreds more times the risk as stock ABC? Does any of this really make sense to you?

The question you need to ask yourself is this:  are most of the current risk ratios based on fluctuating share prices or how the actual firm is valued and how well business is performing?  You guessed it, risk is most often modeled solely on historical share price movements. Can this really be?!? Could the brightest Wall Street practitioners be examining, not only what happened in the past, but analysing only a price chart…something that has very little to do with company fundamentals?

What is risk?

Is Volatility True Risk?

A simple definition of risk would include the probability of a certain outcome. How probable is this stock to go up 10%, down 10% or stay the same? It is easy to assess risk when rolling a die as the numbers and possible outcomes are fixed. But defining risk is not so easy when examining the share prices of a company. First you need to assess the probable outcomes for the company.

  • How likely are they to increase profit by abnormal amounts?
  • How probable is a buyout?
  • What caveats could lower their revenues and profits? How likely is this to occur?

Even if you can answer all the above questions, you then need a degree in behavioral science to determine how investors and institutions might perceive it…and all this against the backdrop of the entire economy. No single person can even fully comprehend the economy and to define risk you need to not only understand how the macro-markets work and forecast the future of the globe, but also the company and how it will be viewed at that time. This is so overwhelming that the experts prefer to simply look at past prices and the way shares were traded and say, “well this worked out pretty good in the past…why not give it another shot just in case it keeps going?” They are suggesting that past volatility is a good indicator of future volatility.

For a moment we will just forget that these ratios are based on historical performance and may not be the most meaningful measures of future risk.   Assume they are right and volatile share prices have something to do with your future risk.

Volatility can, at times, betray that a stock is high risk. Think Enron and WorldCom.

Ouch! This sort of volatility spells trouble.

But take another firm called World Acceptance Corp. This financial company fell hard during the 2008/09 crash. But look at the underlying firm to see if the risk was the same as the companies above. Earnings rose steadily year after year even during the crash. Revenues continued to jump and outstanding shares shrank. I want you to examine the chart below and tell me if you feel that the volatile share prices that lost 75% of their value carried the same risk as the firms above. Pay note to the orange line which shows EPS ttm and the red line which shows earnings yield.

A 15.54% earnings yield coupled with ever increasing total earnings suggests that this was a screaming buy despite the volatility. But if you only looked at the share price drop with a depressing Share ratio you might have assumed that this company was a total bust and one of the worst investments possible. But looking at factors other than historical prices and what lied beneath the hood (and not simply how equity shares were being traded) suggested this was a decent buy. And share prices being 6x higher three years later bears this out.

I go back to my question posed earlier: what does share price movement (and related volatility) have to do with risk? Isolated price action does not tell you whether the excruciating pain is nearing an end or not, whether or not the company has the ammo and firepower to turn the situation around or even withstand the storm, or if this is a great opportunity that you need to start scaling into. Simply chasing price movement is a fools game of trying to guess what’s next based on how the stock is being traded right now. This is like trying to determine if a movie is of good quality by the day to day ticket sales at the domestic box office. But what if nobody is watching the movie and simply trading and continually scalping the tickets for profit? How then do you determine the quality of the movie and whether it will be a winner overseas? The assumption is that everyone else has done their homework and you’ll take a free ride on their backs. But if hardly anyone is looking at firm-based or macro-economic risk factors – what value do share price movements have? How high or how low might share prices go?

Implied Volatility is a Poor Indicator Also

If you choose not to use historical volatility, why not use implied or expected volatility by analyzing the premiums in stock options? Isn’t this the hard proof of how volatile the markets are expected to be by those in the know? In the 2012 paper Long-Term Volatility Forecasting by Nicholas Reitter, evidence is presented showing that the anticipated volatility as determined by stock option prices has little forecasting ability in general.

The VIX or the Volatility Index, may give indication on the current level of fear in the market – but it is another issue altogether to use this volatility index to estimate actual risk. The VIX is also useful for option traders and those making short-term trades on fluctuating premiums in options but the picture is much more murky when using these fear-based ratios to determine the ability of your investments to generate profit and the levels they may be trading at 10 years from now.

The aforementioned paper did indicate that using a long-range trailing chart of 15 years does give some limited ability to determine future volatility. But remember that volatility is not the same as risk. Even if past volatility gives a small indication of future volatility, it does not give us a clue if this firm is a good investment long-term.

Your Advisor’s Definition of Risk

Your financial advisor might say he is not a technical analyst that draws shapes and patterns on charts to create his investment advice, but when he gives you these ratios based on past price performance and dresses it up as a ‘risk-adjusted return’ ratio he is basically telling you to slap some Bollinger Bands on a price chart and trade away for low-risk gains.

The next time you get a ‘risk-adjusted return’ ratio that suggests the stock is a good buy – ask the expert the following questions:

  • Is that ratio based on past performance?
  • Is volatility a constant…is that past performance meaningful for my future investment decision? How so?
  • According to your statistics, which would be a better investment to buy right now… a million dollar house that was discounted with great volatility and loss to $100,000 or the increasing value of government bonds that now have microscopic yields? Can you show me the Sharpe ratios for both?

The current methods of determining risk are woefully inadequate for defining true risk – the long-term loss of your investment dollars and not just a bear market blip. By chasing after historical trading habits that define volatility we are allowing ourselves to be Lemmings and if Investment Johnny slowly walks up to the edge of cliff and jumps…we follow without looking what’s below.

Diversifying Away Risk

“No problem,” you say, “I don’t care about volatility because I follow Modern Portfolio Theory that diversifies away that sort of volatility risk. I choose many different investment products and stocks that behave very independently. When one goes up the other goes down and this creates a smoother ride with lower risk of a total long-term loss.”

The ideals are lofty but the practice is difficult. Part 5 of Wall Street Exposed will tear apart the myth that you can quickly choose a big portfolio of diversified stocks to sit back and enjoy the smooth sailing.


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