“Investing is a problem that has been solved,” Dave Nadig, managing director of ETF.com, likes to say. Keep it simple, hold down costs, diversify, invest for the long run and let the magic of compounding work for you. For most investors and money managers, statistically speaking, it is a high-probability solution.
Despite this, more and more people seem to be ignoring those investor-friendly moves. Instead, they have been embracing higher-risk strategies that hold out the theoretical possibility of higher — and in some cases, much higher — returns. Among the approaches: using leverage, buying farmland or timber acreage, betting on commodities and buying into private-equity and venture-capital funds.
What is behind the new appetite of risk? Let’s consider a few possible culprits:
No. 1. Lower expected returns: Markets are not predictable, but valuations provide broad guidelines about reasonable future return expectations. Traditional measures suggest U.S. stocks are fully or even richly valued; U.S. Treasuries and corporate bonds are offering some of the lowest yields in the postwar era. More than a decade after markets bottomed in 2009, and years after the end of monetary stimulus, there simply are fewer bargains and cheap stocks than there were.
My takeaway from this: investors should ratchet back their expectations of future returns. Clearly, that’s not a popular view and many reject it. Rather than accept more modest gains in the future — say, 2% for bonds and 5% for equities — some participants seem intent on juicing their returns by taking on more risk.
No. 2. Misunderstanding risk: Investors occasionally forget the definition of risk, which can be summed up as the possibility that the actual returns on an investment will be less than the expected returns.
Risk and reward are two sides of the same coin; to have a chance to generate higher returns requires accepting greater risk. Better performance comes with the possibility of worse performance.
Investors occasionally forget that risk is risky.
And in the pursuit of alpha (market-beating performance) many investors forsake beta (market-matching performance) and end up underperforming a benchmark or generating losses. That’s why high-return, low-probability bets have lots of risk and slim odds of reward.
No. 3. Chasing what worked: It is an eternal verity of investing that past performance is no guarantee of future results. It also is the most ignored product-warning label in history.
This explains so much of what happens in investing, with money channeled into what’s in vogue. Often this occurs after most of the gains have been captured. Consider the crowd that piled into hedge funds after the financial crisis. Hedge funds had significantly outperformed benchmarks during the prior two decades, driving up assets under management to about $1.4 trillion by 2008. That run ended after 2009, even as assets doubled to almost $3 trillion by 2015. The result was too much money in too narrow a space, leading to significant underperformance.
But it wasn’t just hedge funds. Consider Bitcoin, if you bought in 2017; residential real estate in 2007; any endowment mimicking the Yale investment model after the 1990s. Disappointment all around. When a successful strategy begins to attract lots of cash, it often means the easy-money phase is over. If you want to know when a sexy new investment is getting toward the end of its run, watch the capital flows.
No. 4. Lottery-ticket investing: The winner-take-all phenomenon is well-documented, not just among sports stars and pop singers, but for venture-capital, private-equity and hedge-fund managers. A small number of investment firms account for most of the gains. If only we could gain access to that exclusive club, our returns would be much better.
This creates what I like to call the Powerball mentality: This is related to item No. 2., or the high-risk, high-return approach to investing. Alas, to gain entree to the best funds, you only need millions of dollars and a time machine so you can go back and invest with the star money managers of today before they achieved their fabulous gains.
No. 5. Late-cycle overconfidence: OK, I had to sneak one cognitive issue in. It has been a full decade since markets reached their lows in March 2009. Enough time has elapsed for people to forget both their pain and the hard lessons of the financial crisis. The same people who swore off equities in 2009, 2010, 2011 and even 2012 are now diving headlong into risky, crowded trades, kicking themselves all the way for not getting fully invested years ago. The lure of a payoff is enough to overcome their post-traumatic financial stress disorder .
It’s hard not to look at this investment landscape and not have the sneaking suspicion that this won’t turn out well — and it may not take very long to find out.
— More by Barry Ritholtz:
Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation.” For more Bloomberg Opinion articles, visit bloomberg.com/opinion.