Rekenthaler Report: The Perpetual Headwind
Investors react to risk more than they anticipate.
The June 2007 chart foretold a dire story. In contrast with conventional finance theory, which states that riskier assets should compensate for their dangers with higher eventual returns, the GMO forecast predicted that the highest absolute returns for the next seven years would accrue, in order, to TIPS, Treasuries, international bonds, and cash. The worst returns would be for small-company stocks, both in the U.S. and abroad, with every single equity category losing money in real terms over that seven-year period.
In contrast, the October 2008 chart shows a powerful advantage for riskier assets. Following 15 months' worth of carnage, all stock categories vaulted to having strongly positive forecasted real returns, with emerging-markets stocks leading the way at nearly 10% real return per annum--an anticipated doubling over the upcoming seven years. Except for TIPS, fixed-income had dropped dramatically, with international bonds and cash at the bottom, expected to make no real profits whatsoever over the time period.
Of course, these predictions represent just one investment manager's viewpoint. They might be dead wrong. But I suspect not. For the most part, GMO's type of common-sense forecasting approach--start with the standard theory that higher-risk assets will enjoy superior returns, then modify those initial estimates by squeezing the returns of assets that are selling at unusually high prices, and pushing up the returns of those that are selling cheaply--tends to be on track. GMO and others who applied such an approach during the late 1990s correctly predicted that big U.S. growth companies would disappoint over the next decade, and that real estate would do very well.
You know the coda. Most investors were happily purchasing riskier fare at the time that the common-sense forecasts such as GMO's said that such securities were overvalued, and most participants are now quite delighted to hoard government debt, when higher-risk investments appear to be unusually attractive. The reasons for this behavior are legion: peer pressure, risk tolerance that grows during bull markets and shrinks during bears, lower aggregate wealth, a shortage of credit, and others. And those reasons reappear in market after market, cycle after cycle. The result: People react to risk more than they anticipate. And by this reaction, they create a perpetual headwind for their investment portfolios.
A Step Behind?
This tendency crosses all investment boundaries, affecting individual investors, advisors, and even the largest of institutions. For example, the largest pension plan in the U.S., California Public Employees' Retirement System (CalPERS), recently announced plans to launch a new "risk management" system later this year. This system will purportedly do a better job than the current approach of preventing the portfolio from exceeding its forecasted loss limits.
Well that's fine, continuous improvement is always welcomed, but one wonders exactly when the new risk-management system will prove its value. I would suspect not for quite a long time. The 2007-08 bomb buried most asset classes so deeply that they will be climbing upward for quite a long time before their prices reach excessive levels, and the benefits of a risk-management system can truly be seen.
You Don't Say
From Yahoo!: "Scientists determine that head-banging is bad for health."
