Investors: Are you a return seeker or a risk manager?
Editorial Note: This post originally appeared on our companion blog, Fiduciary Matters, on April 29, 2016.
Investing, at its most basic level, is a delicate trade-off between return seeking and risk management. For many investors, the factor that dominates their decision making shifts over time with somewhat predictable, and more often than not negative, results.
From fear to greed
I don’t believe that one approach is necessarily always better than the other. I’ve worked with investors in both camps who have been very successful.
Warren Buffett famously advised that investors should “try to be fearful when others are greedy and greedy only when others are fearful.”1 Clearly that advice is easier to dispense than it is to follow: it’s human nature (and the nature of committees) to focus on risk after a period of market stress and to shift the focus back to returns after a period of relative calm.
That’s why risk management was the topic du jour immediately following the global financial crisis. When the market was fearful, our industry’s trade journals and conference circuit were dominated by risk talk. Many institutions demonstrated their renewed commitment to risk management by appointing a Chief Risk Officer, buying a risk management system, or launching an initiative to institutionalize “best practice” risk processes.
It’s taken a 7-year bull market and historically low volatility2, but the pendulum is now swinging back to more of a return seeking mentality. This shift is evidenced by a growing appetite for strategies employing leverage and more and more investment committees and boards once again asking “are we taking enough risk?”
I’ve witnessed this pattern play out multiple times over the course of my career and I can’t help wondering if the current shift away from risk management back towards return seeking will prove to have come at precisely the wrong time. To be clear, none of us know what will spark the next crisis or when it will occur. What we do know, however, is that we are closer to the next crisis than we were yesterday.
So the best guidance I can offer right now is a simple rephrasing of Buffett’s sage advice: investors should lean towards return seeking after a period of chaos rather than after an extended period of relative tranquility. Now is certainly not the time to forget the painful lessons of the past that led to the progress we’ve made on the risk management front.
1 Letter to the Shareholders of Berkshire Hathaway Inc., February 2005.
2 While volatility has increased from historical lows in recent months, the CBOE VIX Index sits at right around 14 on April 26, 2016 which remains well below the historical average of approximately 20.