Investors No Longer Care About Risk
The riskier the asset, the better the performance
In Pursuit of Short-Term Gains
Despite any negative news around the world, you‘ve been able to buy almost any stock and see decent gains.
In the last 6 months alone, the S&P 500 is up 21.22%, reaching all-time highs. In pursuit of short-term gains, investors are willing to buy almost anything without even understanding what they’re buying.
When Elon Musk tweeted about an app called signal, a stock that shared a similar name soared by 11,708%. Just because he tweeted about something that had a similar name to it, an unrelated stock saw massive gains.
Now, this appetite for risk is not only found in this anecdotal example of Elon Musk’s tweet. Bitcoin, possibly the riskiest and most volatile asset in the market, tripled its value in three months. And then there are IPO’s that all seem to double in the first day.
The riskier the asset the better the performance.
A lot has changed in the last year. We went from investors doubling down on cash amid the fear of the virus, to investors piling into the most speculative investments, like Bitcoin or IPO’s, as quickly as possible.
In this article don’t expect me to talk about Bitcoin or Ethereum. Instead, we’ll try to make sense of what’s going on. The question is…
How long can this continue?
Howard Marks is addressing this questions in the memo “Coming into Focus”.
He talks about the risk-free rate. That is money you can earn for free. Money that you can earn without taking on risk. He explains how the risk-free rate affects investment behaviour and the rest of the market:
“The yield on the 30-day Treasury bill is often referred to as the risk-free rate. There’s no credit risk, since the obligor is the government (which can print all the money it needs for repayment), and there’s no risk of losing purchasing power to inflation, since repayment at maturity is only days away”.
Since the risk-free rate can be earned with complete safety, and most people prefer safety over risk, investors shouldn’t take risk without being compensated for doing so.
As investments increase in terms of the level of uncertainty, an incremental “risk premium” should be incorporated in their potential returns. The graph that Howard Marks uses to describe the relationship between risk and return is as follows:
You can see that the very low risk and return investment like Treasuries are down there at the bottom left. That’s the risk-free rate, that’s what you can earn without taking on any risk. As we go up the graph we have high-grade bonds and then quality stocks right there in the middle.
Then come aggressive stocks, which grow their revenues a little bit faster and are more based on future earnings. At the end of the graph, we have private equity which is by far more risky than publicly traded companies.
Making Sense of This Nonsense
Over the past year, the risk free-rate has been dropped significantly, due to the federal fund rate dropping. Therefore, the expected return across the entire asset line has dropped accordingly:
It doesn’t matter what you’re investing in, the expected returns have been lowered because the risk-free rate is lower. This has caused investors to move up the asset line seeking the same type of returns and doing that by taking on more risk.
The one thing Howard Marks is missing in this graph, are the more speculative and risky investments, investors are now moving into. Above the aggressive stocks and high yield bonds, we have IPO’s doubling in price the first day. And of course Bitcoin and other cryptocurrencies.
As a result of the federal fund rate being so low, and the risk-free rate dropping to near bottom investors are moving up this line seeking riskier and riskier investments in the pursuit of returns.
It’s difficult to answer how long this can go on for. Nobody knows.
What we know is that we are at extreme high valuations which are obviously supported by massive amounts of stimulus. The thing that is keeping it going is the Fed. With rates at zero and promises to stay at zero, the Fed allows for valuations to be record-breakingly high.
With all that’s going on, I’m not gonna sit on the sideline. The Fed is keeping interest rates low. Investors are going to continue to put money into riskier investments in the pursuit of returns. If you sit on the sideline, chances are, you’re going to miss out on a lot of returns.
We All Run Into The Same Problem
At the end of the day, we all run into the same problem of where to put our money. There are a few options:
- You could put it into these speculative investments like IPO’s or Bitcoin and take on a lot of risks.
- Or you could put it into a savings account and earn essentially nothing.
- Somewhere in between.
I prefer somewhere in between. I like to invest in quality blue-chip companies with stable cash flows that reward me as a shareholder.
I know that I’m not going to have the most breakthrough returns. You will see other people who post huge returns on social media with very speculative investments. Sometimes these speculative investments turn out good, and sometimes they have devastating losses.
I don’t want to take that kind of risk. I care about my money a lot. I know that it’s going to be a slow and steady way of earning money. For me, that’s the right balance between risk and reward.
Takeaway
In Pursuit of Short-Term Gains
- Investors are willing to buy almost anything without even understanding what they’re buying.
- This nonsense can be explained by the risk-free rate, which is money you can earn for free (without taking on any risk).
- As a result of the federal fund rate being so low, the risk-free rate dropped to near bottom.
Making Sense of This Nonsense
- Investors are now moving up the asset line (to IPO’s or Crypto) seeking the same type of returns and doing that by taking on more risk.
- Since the Fed is keeping interest rates low, investors will continue to put money into riskier investments in the pursuit of returns.
- If you sit on the sideline, chances are, you’re going to miss out on a lot of returns.
We All Run Into the Same Problems
- You could put your money into these speculative investments like IPO’s or Bitcoin and take on a lot of risks. Or you could put it into a savings account and earn essentially nothing.
- I prefer somewhere in between. I know that it’s going to be a slow and steady way of earning money and I’m not going to have the most breakthrough returns.
- I care about my money a lot. For me, that’s the right balance between risk and reward.
On a final note, I encourage you to research on what kind of risk you want to take on. Do it with a level of caution and be aware that investors seek short-term gains as time goes on. We don’t know how long this will continue without reverting. Keep in mind, the more risk you take on, the more your chances of substantial loss.
