“A big challenge for an advisor is to help clients understand that this was a normal outcome and that, ‘No, we don’t need to adjust our portfolio because this quarter it went down. This was in the range of perfectly reasonable outcomes.’”
Kenneth French
Professor of Finance, Dartmouth
“I define risk as uncertainty about lifetime consumption broadly defined. People invest because they want to use their wealth in the future. Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation, and medical care. Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children. My definition of lifetime consumption includes all these and any other anticipated uses of wealth. Investors like a high expected return because it increases the expected wealth that will be available to spend or give away. And everything else the same, risk averse investors prefer less uncertainty about their future wealth.”
Kenneth French
Professor of Finance, Dartmouth
“Staying rich requires an entirely different approach from getting rich. It might be said that one gets rich by working hard and taking big risks, and that one stays rich by limiting risk and not spending too much.”
Aswath Damodaran and Peter Bernstein
Below are the returns of some of the key indices we follow. As you can see, it was a tough quarter, as the Russian invasion of Ukraine and inflation both caused some angst in the marketplace.
| Data Series | 3 Months | 6 Months | 1 Year | 3 Years | 5 Years | 10 Years |
| Russell 3000 | -5.28% | 3.51% | 11.92% | 18.24% | 15.40% | 14.28% |
| S&P 500 | -4.60% | 5.92% | 15.65% | 18.92% | 15.99% | 14.64% |
| Russell 2000 | -7.53% | -5.55% | -5.79% | 11.74% | 9.74% | 11.04% |
| Russell 2000 Value | -2.40% | 1.85% | 3.32% | 12.73% | 8.57% | 10.54% |
| MSCI World ex USA (net div.) | -4.81% | -1.82% | 3.04% | 8.55% | 7.14% | 6.25% |
| MSCI World ex USA Small Cap (net div.) | -7.23% | -6.87% | -1.69% | 9.55% | 7.79% | 7.78% |
| MSCI Emerging Markets (net div.) | -6.97% | -8.20% | -11.37% | 4.94% | 5.98% | 3.36% |
| Bloomberg U.S. Treasury Bond 1-5 Years | -3.37% | -4.08% | -3.96% | 0.87% | 1.13% | 1.01% |
| ICE BofA 1-Year US Treasury Note | -0.80% | -0.98% | -0.94% | 1.01% | 1.22% | 0.78% |
We expect markets to be volatile in the intermediate term, as the Russian invasion of Ukraine has raised the level of uncertainty. The invasion, combined with rapid inflation, has left investors a bit unsettled.
We have received questions on how to deal with both the uncertainty and how to invest in this market climate. Dimensional has put out a couple of pieces that we think are helpful, and I am incorporating them into the Newsletter below. In addition, Nobel Laureate Gene Fama was interviewed by the New York Times after the Russia – Ukraine war broke out. The interview was published March 9, 2022.
Jeff Sommer asked Fama “What message, if any, have the markets been imparting since the start of the coronavirus pandemic, or, now, during the war in Ukraine, when stocks rise and fall with no discernible regard for human life?”
The markets aren’t telling us much, he said. Some people interpret efficient markets as the source of “the wisdom of crowds”. This is the idea that, together, through the mediation of markets, crowds of people come up with answers about important questions that are much smarter than the conclusion of any one individual. But there’s no great wisdom evident now.
The markets are struggling to come up with prices for stocks, bonds, commodities, all kinds of things, Fama said. They aren’t necessarily conveying any deeper meaning.
“Basically, we’re in a period where we have had an injection of uncertainty into the world, so speculative prices are going to go up and down in response,” he added. “People are continuously trying to evaluate information. But it’s impossible for them, given the amount of uncertainty that’s out there, to come up with good answers.”
“But that doesn’t mean the market is inefficient,” he added. “Markets can be rational without politics being rational or people always being rational. The problem with pricing is a question of how much is knowable right now. How’s this Russia thing going to work out? Who knows?”
He then further stated that “there is always risk in the stock market, always. It never goes away. People have to remember that”. And, he said, it’s impossible to know which way the market is heading. “My whole life’s work says you can’t answer that question.”
Do Downturns Lead to Down Years?
Dimensional Fund Advisors – Apr 12, 2022
Stock market slides over a few days or months may lead investors to anticipate a down year. But a broad US market index had positive returns in 17 of the past 20 calendar years, despite some notable dips in many of those years. Even in 2020, when there were sharp market declines associated with the coronavirus pandemic, US stocks ended the year with gains of 21%.
Volatility is a normal part of investing. Tumbles may be scary, but they shouldn’t be surprising. A long-term focus can help investors keep perspective.
How to View Risk
Ken French, Gene Fama’s prolific co-author on many academic papers, wrote an essay recently on 5 Things I Know About Investing. The link is here. https://www.dimensional.com/us-en/insights/five-things-i-know-about-investing
The first of his 5 Things had to do with how to view risk. I thought it was worth repeating below.
1. Risk is uncertainty about lifetime consumption.
“Most investors are risk averse. Given the expected return, they prefer lower risk, and given the level of risk, they prefer higher expected return. Most investors understand that the expected return on an investment is essentially the best guess of what the return will be. There is a lot more confusion about risk. When I ask students, investors, and friends what risk means I get conflicting answers. Some say it is the potential for loss. Others suggest it’s the volatility of the return. And others say it’s beta, from the CAPM. Good portfolio design requires a clear understanding of risk.
I define risk as uncertainty about lifetime consumption broadly defined. People invest because they want to use their wealth in the future. Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation, and medical care. Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children. My definition of lifetime consumption includes all these and any other anticipated uses of wealth. Investors like a high expected return because it increases the expected wealth that will be available to spend or give away. And everything else the same, risk averse investors prefer less uncertainty about their future wealth.
If people don’t like uncertainty about future wealth, shouldn’t we measure each investment’s risk by its potential for losses or the volatility of its returns? No. Those definitions miss important interactions within an investor’s portfolio and, even more important, between the portfolio return and the investor’s other sources or uses of future wealth.
My goal is a portfolio I can justify to myself today, based on the information available now. Because unexpected returns will dominate the outcome, I won’t judge my choice on what the portfolio delivers tomorrow.
Think about homeowner’s insurance. If we consider only the policy, this investment is as bad as a lottery ticket. First, there’s lots of uncertainty about the outcome. Typically, the policyholder pays the premium and gets nothing back, but there is always the chance of a big payoff. Second, if the insurance company rationally expects to make money on the contract, a rational policyholder’s expected return must be negative. Why would a risk averse homeowner choose a volatile investment with a negative expected return? Because insurance reduces the uncertainty of his or her lifetime consumption. The probability that a disaster will destroy any specific policyholder’s house is tiny, but if it does, the loss to that homeowner can be catastrophic. Most homeowners are happy to pay the annual insurance premium to eliminate this potential hit to wealth and lifetime consumption.
In that same spirit, it is particularly risky to invest most of your savings in your employer’s stock. As the former employees of Enron might warn us, this can be a remarkably unfortunate way to put all your eggs in one basket. Enron was an energy and trading company based in Houston, Texas. After roughly a decade of phenomenal success, Enron filed for bankruptcy in 2001. Many employees had most if not all their 401(k) in Enron stock and lost their job and retirement savings at the same time. A better understanding of risk might have led them to a retirement portfolio that reduced their uncertainty about lifetime consumption.
Liability driven investing is another way to manage the uncertainty about lifetime consumption. My friend Jeff Coyle is a financial advisor in Southern California who has spoken to most of the classes I have taught over the last 25 years. He describes a client who hired a shipyard in Italy to build a large yacht. The amount and timing of the payments were known, but the obligations were in euros. Jeff took this liability off the table by buying government bonds that delivered the euros needed when each payment was due. Those of us with more mundane obligations can use the same approach. If you are stretching to buy your first home, for example, you might move the savings you will need at closing into a safe money market account today.
The general takeaway here is to think about risk holistically. How will a potential investment vary with your existing portfolio and with your other sources and uses of wealth? More succinctly, how will it affect the uncertainty about your lifetime consumption?”
We know these are uncertain times. When there is uncertainty, there is often more volatility in the market. As Eduardo Repetto, Chief Investment Officer of Avantis Investors and former co-CEO of Dimensional Advisors, has written with his colleague at the time Jacobo Rodriquez:
“Volatility and cross-sectional dispersion bring uncertainty, which in turn brings anxiety. The best way to mitigate that uncertainty is to be broadly diversified within and across asset classes at all times, so that investors need not worry about whether they own the stocks that earn the returns of those asset classes or whether they are fully invested in the markets when they turn.”
By the way, here is a good piece on uncertainty by Allison Schrager, a PhD in economics from Columbia University and former Dimensional employee. It is very good, and distinguishes between risk, which can be managed, and uncertainty, which is all the things you cannot anticipate or measure. Managing Uncertainty – by Allison Schrager – Known Unknowns (substack.com)
Until next time,
Mike and Emily