GMO Quarterly Letter

Up At Night

Ben Inker

Executive Summary
Investors spend a lot of time worrying about what can go wrong for their portfolios. This is a worthwhile and, indeed, essential exercise, but the obvious corollary activity, protecting a portfolio from what can go wrong, is less clearly a good idea. This seeming paradox can be disentangled by recognizing that it is impossible to determine if you are taking an appropriate amount of risk without understanding what the downside is for your portfolio, which means you simply have to do the exercise of understanding what can go wrong. Buying insurance for your portfolio to reduce that downside, however, is a much dicier proposition, leaving you generally either paying so much for broad insurance that you might as well own less in risky assets in the first place or buying insurance for such a narrow range of events that you haven’t protected your portfolio that much at all. This is not universally true, and it can make sense to hedge a piece of the risk that goes along with an asset whose other characteristics you like. It can also make sense to shift the assets you own in the first place given the particular risks that seem most important for your portfolio. For example, in our BenchmarkFree Allocation Strategy we are currently hedging a piece of the risk in emerging markets to protect against the possibility of US dollar strength, and we are choosing to hold alternative strategies and inflation-linked bonds versus equities and conventional bonds to protect against the risk of rising inflation and rising discount rates.

Perhaps the most common question I get from clients is “What keeps you up at night?” This question is a shorthand way of asking what potential economic, political, or market events are we most worried about, and what, if anything, are we doing in our portfolios to deal with them. It is the kind of question that any responsible investment manager is supposed to have a thoughtful answer to, and within the context of the couple of minutes that it is generally expected that I will dedicate to answering a question, I will do my best to answer it thoughtfully. But risk is a more nuanced issue than most people make it out to be, and in this quarterly I will try to dig further into the issue than I can in a couple of minutes. Whether it still seems a thoughtful answer I will have to leave to the reader. The business of investing is inherently about taking

The business of investing is inherently about taking risk. While there are some risks it is possible to avoid taking – you don’t have to worry about the risk of financing being taken away from you if you don’t lever your portfolio, for example – some important risks are unavoidable.1 The reason why the returns to stocks are higher than T-Bills is because they involve more risk of loss in a depression. The same is true for credit, real estate, venture capital, infrastructure, and everything else generally referred to as “risk assets.” Even government bonds with longer maturities than T-Bills generally have to offer a higher yield to compensate for the risk of inflation and rising interest rates. As a result, probably the most important question in determining the long-term returns investors can earn is how much risk they are prepared to take. Those prepared to take more risk should generally expect higher returns in the long run. But taking too much risk can also lead to disaster for investors. An investor holding a 60/40 S&P 500/Treasury bond portfolio in September 1929 would have had 39% of his money remaining by June of 1932. An investor holding 100% S&P Composite would have retained 18% of his money, and one leveraging his investment in the S&P 2:1 would have retained 1.8% of his money. Losing 61% of your money is no fun, but losing 82% is an awful lot worse, and losing 98.2% is too horrifying to contemplate. The brave investor who somehow kept going with the leveraged strategy would, indeed, have recovered eventually, but it’s hard to imagine how one could actually stick to such a strategy.2 The 100% S&P strategy outperformed the 60/40 strategy by about 1.5% annually since 1920, so there was, in fact, a higher return for the additional risk. Whether an investor would have been able to take that additional risk, however, is another matter.

How much risk can you take?
Determining how much risk you can take as an investor is a crucial exercise. There are at least two aspects to it, generally referred to as risk capacity and risk appetite. Plenty of commentators have written on these concepts, so I won’t spend a lot of time discussing them here other than to say it is a bad idea to ignore either aspect. Risk capacity refers to the extent of loss a person or organization can withstand without having to significantly change spending patterns. An endowment that is responsible for covering a relatively small percentage of an institution’s budget probably has more risk capacity than a foundation, where spending from the corpus must cover 100% of spending. And a 25-yearold who is 40 years from retirement probably has more risk capacity in his retirement savings than a 70-year-old who relies on those savings for a large portion of his necessities.

It’s hard to quarrel with the idea that different investors have different risk capacities. It is easier to argue that risk appetite is more about a lack of education on investing – an investor who has much less risk appetite than risk capacity will wind up leaving a lot of return on the table over the years for no good objective reason. But the converse problem is quite real as well. An investor who sold risk assets in 2009 due to heightened fears of depression or just the shock of the losses suffered in the financial crisis clearly held a portfolio too risky for his risk appetite, regardless of his true risk capacity.

Calculating the risk of your portfolio is a complex exercise, so I’d like to keep to the conceptual end of things here. In thinking about risk for a portfolio, I believe you need to worry about both a few risks that are eternal – the risk of depression and the risk of unanticipated inflation come to mind as eternal risks – as well as risks that come out of the unique economic, political, and environmental issues that are specific to the world today.

Why not hedge your risks?
Any homeowner who fails to insure his house against theft and damage is rightly considered to be reckless. Plenty of insurance products are available for portfolios, so why not insure your portfolio, too?3 There are a number of reasons why the analogy fails. First and foremost, a house that is one quarter destroyed is not the same as a house that is three quarters the size. If a fire or tornado has destroyed one of the walls of your house it has to be repaired. You can’t decide to avoid the affected rooms and go on with your life otherwise unaffected. But a portfolio that has lost one quarter of its value is simply a portfolio that is 75% of its original size. It is disappointing, to be sure, but it doesn’t actually impair the proper functioning of the portfolio. It is possible that its smaller size does functionally impair your ability to live off of it, however. This is where risk capacity comes in, and if a 25% loss is unacceptable for whatever reason, it makes sense to build a portfolio where the risk of such a loss is very low.