Zen And The Art Of Risk Management

“Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.” –Seth Klarman

Growing wealth occurs over a long time horizon, including many bullish and bearish market cycles. While making the most out of bull markets is important, it is equally important to avoid letting the inevitable bear markets reverse your progress.

Making this task much more difficult are extreme market environments and inane investor beliefs at such times. When markets are frothy and grossly overvalued, greed takes over, leading to lofty performance expectations and excessive risk stances. Equally tricky is buying when fear grips the markets.

In both extremes and all points in between, we must maintain investor Zen. The best way to accomplish such mindfulness and awareness of market surroundings is to understand the risks and rewards present in markets. Zen-like awareness allows us to run with the bulls and hide from the bears.

Measuring Risk

The price of every almost every asset represents the cost to receive cash flows in the future. With equities, for instance, we are buying future earnings.

When someone buys Apple stock, they are an owner of Apple. Like every company, public or private, Apple has options with what they can do with their earnings. The decision frequently boils down to paying them out as a dividend or reinvesting them into the company. At times they may hold cash, effectively delaying the decision.

The chart below compares the rolling ten-year average dividend yield and earnings yield for the S&P 500. As shown, half to two-thirds of earnings get paid out as dividends.

Zen, Zen and the Art of Risk Management

When determining the valuation for a company or index, we must understand that future earnings are what we are valuing. The reinvestment or dividend distribution decision is secondary. 

 

Do Valuations Dictate Returns?

Short-term price changes of stocks are based solely on liquidity, or the balance of buyers and sellers. Over longer periods, price changes become more dependent on valuations and less on supply and demand. The following scatter plots compare CAPE valuations to subsequent 10-year and 3-month returns to highlight this fact.

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