Risk management is a hard sell!

Equity mutual funds are getting a late Christmas gift this month: they are finally able to drop return data from 2008 from the calculation of their five-year performance numbers. Why is that important?

In 2008, global equity markets fell between 30-54% (as if we need reminding!). Given that mutual funds generally report one, three, five and ten year historical performance, dropping 2008 from their critical five-year returns will optically improve the numbers, no question. But what does it tell us about risk? Those better five-year numbers might attract some investors to a level of risk they don’t want — and perhaps don’t understand. Let’s look back for a moment.

Many investors amended their view on risk after the dreadful market collapse of 2008/2009 – swearing off stocks and retreating to cash and the safety of bonds.  At that time it became apparent that some did not appreciate how much risk they’d had in their stock portfolios. Or, as Warren Buffet famously said, “only when the tide goes out do you discover who’s been swimming naked.”

Fast forward to today and the rising tide of positive stock market performance over the past five years has lifted all boats — not withstanding the modest pullback this month. 2013, in particular, was a bumper year for equities – with the S&P 500 rising 30%, Nasdaq up more than 38%; even European markets had their best year since 2009. Global economic fundamentals have improved and confidence is returning to markets.

So is it time to relax and not worry about the downside so much?

We don’t think so.

Markets move in cycles, driven by many factors. And a stronger economy does not always mean a rising stock market. At any given time there are pundits on both sides of the “bull/bear” discussion and it can be difficult to sort through the contradictory opinions. But markets don’t go in one direction forever, and after a sustained upward swing, our concern is that, once again, some investors may be blithely ignoring risks in an effort to make up lost ground after the last major correction. Financial pundit and investor, Jim Rogers was recently asked what he thought was the biggest risk to the stock markets today? ‘Madness,’ he said. In other words, by ignoring the risk side of the equation, investors could be setting themselves up for a fall.

A few basic principles can help to protect capital from market corrections:

• Proper diversification is critical. Stocks, bonds, real estate, mortgages, private equities, etc. There is good reason why the country’s largest pension funds are broadly invested in many asset categories, it reduces risk and improves returns. (I’ll admit to our own bias here as well.)
• The price you pay for an investment matters. Not overpaying is a good way to stay out of trouble.
• The best offence is a good defense. This is another way of saying “don’t overpay”.
• Keeping some cash, or “dry powder”, is a good way to reduce volatility and ensure you have the ability to take advantage of a bargain if one comes along.
• If you do a good job of managing risk and you are patient the returns will follow.

It has been gratifying to see patience rewarded with better returns over the past few years. But let’s not forget the much less popular corollary of good returns: good risk management.