Whenever anyone refers to the price action in financial markets as “risk-on” or “risk-off,” it makes me lose my freaking mind, says Landon Whaley of Whaley Global Research.
It’s like being forced to watch the 1985 Memorial Day Massacre all over again while simultaneously listening to the Beaches soundtrack on repeat.
There is no such thing as financial market risk being “on” or “off.” This isn’t the Karate Kid, you aren’t Ralph Macchio, and I’m sure as heck, not Mr. Miyagi. There is no risk-on or risk-off, Daniel-son.
Risk is always on, my friends, and if you aren’t convinced of that fact, look no further than the past two weeks. Investors buying the opening bid on Monday based on vaccine headlines have had sand kicked in their face the remainder of each week.
The problem is that most investors have no idea what the word “risk” really means.
Raise your hand if you’ve ever been put to sleep by your financial advisor or money manager spewing terms like beta, standard deviation, kurtosis, and skewness. I feel your pain.
Much of the confusion comes from the fact that the words “risk” and “volatility” are used interchangeably. Let me be clear; risk is not volatility; they are two different beasts.
Standard deviation and other volatility measures may make you feel warm and cozy, but they can’t help you understand risk because risk is not a number.
So, what exactly is risk?
Risk is an estimation of the likelihood of a permanent loss of capital if an unfavorable event occurs.
I’ve left you wanting, haven’t I?
You wanted me to tell you the index, calculation, or statistical measure that would help you discern just how much risk exists in the world, and more importantly, in your portfolio. I’m sorry, but I can’t. We can’t boil risk down to a number, but we can assess the probabilities of various outcomes and then position our portfolios in a way that tilts the scales in our favor.
The Bottom Line
Human beings are hardwired to hate uncertainty. But if you think about it, there is no great reward if you don’t embrace uncertainty. The first time you asked your significant other out on a date, were you certain he or she would say yes? Of course not. There was uncertainty and a possible loss of ego if an unfavorable event occurred, and that person said “no.”
If you’re thinking of leaving a 20-year steady-paying gig to join a start-up because you want to control your own destiny and earn “buy-your-own-island” money, is there certainty? Nope. My friends, all of life’s greatest rewards live in the land of uncertainty, and successful investing is no different.
This past week’s uncertainty revolved around Covid lockdowns and a stimulus package; next week, it will be something else.
To earn high, risk-adjusted returns, you must embrace uncertainty and have a process for understanding the ever-changing and unintended sources of risk that lurk in financial markets.
To learn more about Lanndon Whaley, please visit WhaleyGlobalResearch.com.