What is risk? That’s an ongoing debate between the different investment tribes.
The predominant usage within the investment world equates risk with volatility. And given that the industry displays the same recency bias as behavioral finance specialists have identified in individuals, the low volatility world is starting to be accepted as normal.
As shown in the bottom panel of the chart, volatility is minimal. The VIX shows implied volatility, which correlates very highly with realized volatility on the S&P 500 (which is now the lowest it has been since 1995).
So, stocks are less volatile. Does that make them less risky?
In the top panel is another way to think about risk. The trend over the three years shown has clearly been to pay more for a dollar of earnings — a lot more. This is a Bloomberg-calculated ratio and there are many other valuation measures that could be looked at. In my mind, the body of evidence is that valuations are stretched, which doesn’t mean that the trend won’t continue. But at what point does risk management kick in for you? Or doesn’t it?
This is why knowing your investment beliefs is important. The prognosticators don’t know where valuations will go and most of them are in the business of recommending stocks come hell or high water. Plus, your advisors (whether you are an individual investor or an institutional one) will talk about risk in a way that’s clinical and probably irrelevant.
Now would be a good time to get into a deeper discussion of what risk really is for you. (Chart: Bloomberg terminal.)
A great new book by Nick Gogerty is the subject of my latest essay. The parallels between ecology and economy are finely drawn by Gogerty, and I promise that you’ll think differently about the nature of value after you read it. It’s not just for those of the “value” persuasion, however, and the scores of illustrations will delight and educate you.