Is Investing Starting to Get Difficult Again?

Executive Summary

In the first three months of 2018, volatility rose and correlations between stocks and bonds shifted. In other words, last quarter looked a lot more like the average conditions investors have experienced over the last 150 years than the very low volatility and strongly negative stock/bond correlations of more recent memory. The change, albeit only over a short period, should have investors evaluating whether the “easy” environment that we’ve seen through this bull market will continue. If it does, the returns we “deserve” to earn as investors should be low. If not, we can hope for a bumpier but more profitable future in the long run. Which path will the future take? My money is on the latter. As Herman Minsky put it, “Stability breeds instability.”

For the last eight years, investing has seemed to be a pretty easy activity to most observers.1 Not only have markets given strong returns, but the apparent riskiness of both individual assets and overall portfolios has been low. It has not simply been the lack of giant, horrifying market dislocations that gives the impression of low risk, but the combination of very low general market volatility and an extremely friendly correlation structure such that stocks and bonds have been wonderfully diversifying. For most investors, this has been a happy combination. For those investors targeting a given level of volatility, whether through risk parity or otherwise, it has been a license to lever up their exposures significantly, to generally good results. Last quarter, investing started to seem a little harder. Not only were returns to most assets mildly negative, but volatility rose and correlations shifted. That’s a good thing, probably a necessary thing if investors are to achieve their long-term goals. On the other hand, we’ve only started the transition from easy to hard, and that path is, almost by definition, not a pleasant one. Investing is often a case of “be careful what you wish for.” “Easy” is fun in the shorter term, and the shorter term can go on for a surprising amount of time, but it winds up being self-defeating. “Hard” is, well, hard, and it’s hard to like things that are hard. Personally, I’m hoping for a return to hard. Not only should it lead to better long-term returns to investors, but it is also a good deal more interesting. Maybe last quarter was a blip and we are going to go back to “easy” for a while longer. If determining when easy turns to hard were easy, well, hard wouldn’t be as hard. But portfolios built for “easy” are poorly designed for “hard.” If conditions prevailing in the first part of this year persist, asset valuations will very likely have to fall, and the process could become disorderly if levered positions have to be unwound reasonably quickly.

So, what is investing again?

A decent working definition of investing is deploying capital to perform an economic function for which some rational counterparty is willing to compensate you. That may seem like a pointlessly broad definition, but in reality, keeping it in mind can really help you determine whether an activity is actually “investing” in the first place, as well as how much you should expect to make from an investing activity. The investing world is not perfectly efficient, and a counterparty might have different goals and incentives than you predict, but even still I think it’s a surprisingly helpful framework. Some ways of using this framework are discussed in the paper “Back to Basics”2 from a few years ago, but I’d like to relate it to “easy” and “hard” in recent market conditions.