Is Your Concept Of Risk Wrong?

The Dow passed 20,000 this week in what has been the second fastest pace for a 1,000-point milestone in the history of the index.
The exuberance of surpassing such a milestone could push the Dow higher still, but the reality of it is that while 20,000 is a sexy number—look at all those zeros—it likely hasn’t benefitted you much if at all.
With all the excitement from the media, its seems that many have forgotten that the Dow isn’t the entire stock market. Not by a long shot.
In fact, it’s just a weighted average of the fortunes of only 30 big stocks like General Electric, Apple, Wal-Mart, and Exxon Mobil. It doesn’t include companies like Facebook, Amazon, or Alphabet, and doesn’t tell us anything about small caps or mid-caps.
While it makes more sense to look to broader indexes like the S&P 500 or the Russell 2,000 to understand how the market is doing, the Dow is the most watched measure of stock market performance for the majority of Americans.
You could contribute this to the index having been around since 1896, but considering that it only represents 30 of the thousands of stocks that make up the broader market and that its price weighted—meaning that outsize moves by any one of the stocks in the Dow can have a big impact,—looking at its milestones is more psychological than material.
For me, Dow 20,000 reminds me of just how long we’ve been in this bull market, and thus makes me think about how much longer the bull market can last. I’m far more interested to see what happens now that the 20,000 ceiling has been broken than I am that it has been.
Considering the length of this bull market, and the beginnings of dangerous echoes of a “new normal,” I’ve wondered how much investors are really thinking about risk and preparing for an inevitable change in sentiment.
Which brings me to Sven Carlin. I’ve talked about Sven a lot over the past few weeks. He’s a PhD hedge fund manager and the talented weekday contributor to our Investiv Daily newsletter.
On Wednesday of this week, we published an article from Sven on really understanding risk. He had the following to say:
“In the financial world and academia, the concept taken for granted is that the higher the risk is, the higher the potential return is and vice versa. I find the concept completely flawed because, first, I don’t estimate risk through volatility (standard deviation) and secondly, when the risks are highest according to standard deviation models, it seems that they are in fact the lowest because there is no other way than up for the stock market. What determines your return is never risk but something much simpler, price.” In other words, if the market fell 50% tomorrow, most would say that the market is risky because of increased volatility. But the reality would be that stocks would simply be much cheaper to invest in than they were before, and therefore you could expect higher returns because you would be buying for much cheaper prices.
In the days after Dow 20,000, it’s ever more apparent that the market is incredibly overvalued and that reward versus risk is skewed much more to the downside.
In such an environment, you have to wonder when the next black swan event will come. Will it be a halt in global trade that leads us into the next global recession? That’s certainly possible given the current political rhetoric, but it could also be something completely different that crashes the market.
But I doubt that when the next black swan comes and we’re talking about “Dow 10,000” on the way down that many of us will say we saw it coming.
In Sven’s words:
“When a black swan comes along, all the assumptions that keep the financial world stable fall and new assumptions are created, with huge repercussions on asset prices. The funny thing is that black swans happen all the time. Recent examples of a black swan are the dotcom crash, and the fall of Lehman Brothers as those are both easily explained in hindsight but the large majority of the financial world didn’t see them coming at the time. “I don’t know what kind of black swan awaits us in the future, but I am sure there is one in the making and it can’t be predicted by standard risk measures.” The moral of this story is to be vigilant in managing risk and to be prepared for the next crash because it is coming. The Dow has surpassed the 20,000 level, and the risks have risen right along with it.
To mitigate some of the risk of the U.S. market, diversifying into emerging markets is a great option. Sven is also the brain behind our soon-to-be released members-only Global Growth Stocks newsletter. This newsletter delivers an undervalued growth stock pick every month that exposes investors to the fastest-growing emerging markets.
I’ve had the pleasure of being the editor for each issue that he’s written so far, and you won’t find better content on the emerging world anywhere else.