Tombstone of High Returns is High Volatility

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Dear fellow investors,

A couple of weeks ago, we gave a presentation at the first annual Smead Investor Conference near our headquarters in Phoenix. Our goal in the presentation was to help frame how investors think about volatility, or what investors really worry about, drawdowns. We feel it is important for our investors to think about this because our industry and the academics that try to produce thought leadership frame returns purely in the light of risk, also known as volatility.

In my 15-year career in the investment business, I don’t think there has been nearly as much weight to making money as there has been in limiting volatility. This creates a good picture of what investors will focus on. It also leaves the stock markets with a problem. If stocks have more volatility than in the recent past, investors will pay less for a broad basket of stocks like the S&P 500 Index, regardless of its underlying economics. Again, they’ve only been trained to pay for or reward strategies and assets with less volatility.

In a Bloomberg article titled “Days of Easy Speculation Look Numbered in War-Shaken Stocks,” writer Katie Greifeld lays out the newly-volatile situations investors weren’t pricing in just a short time ago. “First, it was inflation. Then came shaky tech earnings. Now Russia. Slowly, then all of a sudden, forces are gathering that threaten to wring out the excesses that defined the post-pandemic era in markets.”

These are all risks that weren’t comprehendible one year ago. She goes on to say, “Put together, however, they are sowing a sense of exhaustion among traders, sapping sentiment as investors struggle to find reasons to be bullish.” This exhaustion is what happens when volatility increases.

Authors Tim Lee, Jamie Lee and Kevin Coldiron argue that this lack of volatility happens over a carry regime in their book The Rise of Carry. Carry is a term commonly used when talking about carry trades. These authors write:

A currency Carry trade involves an implicit bet on the exchange rate for the borrowed currency in terms of the investment remaining relatively stable. Even for the most attractive of currency carry trades a large adverse move in the currency exchange rates can easily wipe out the interest rate spread. So the currency carry trade is, in essence a bet on the exchange rate volatility being low, at least relative to what the market might expect. It can therefore be thought of as a “volatility-selling” trade—a bet on volatility declining or at least being low relative to market expectations.

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