Gregory Kolb, portfolio manager at Perkins Investment Management argues that risks need to be acknowledged, avoided and managed.
“A billion here, a billion there, and pretty soon you’re talking real money.” Used for decades to describe the perceived high and ever-increasing level of government expenditures, this memorable phrase of unclear origin may also offer insight for those building investment portfolios today. Consider a slightly modified version: Potential loss here, potential loss there, and pretty soon you’re talking real Risk, with a capital “R”.
In reviewing the primary options available for investment – stocks, bonds and cash – noticing that each has its problems is unfortunately the easy part of the analysis. Stock P/E ratios have expanded dramatically over the past six years, reaching levels unseen for quite some time and exposing investors to any reversal in underlying confidence. Bond yields have fallen to extraordinarily low levels in nominal terms, thus presenting investors with the possibility of negative real returns should inflation or credit quality prove problematic down the line. Cash returns nothing today – as discussed in a prior Outlook – and similar to bonds, holds the prospect of lagging inflation over time. There is also real estate, which for many investors means their house. While home prices may not be out of line with long-term historical valuation parameters, most homeowners have learned the lesson that house prices can in fact decline, so yes, there is risk in this asset class too. In total, it seems the investment landscape today holds plenty of risk.
Beyond the bedrock approach of buying cheap assets, diversification can be of great assistance in building a strong portfolio, one with ample expected return but not too much risk. In theory, when one asset price zigs, another may zag. By combining assets with differing return and risk profiles, the characteristics of a portfolio may be superior to its individual components. In practice today, however, the yield on a traditional 60/40 stock and bond portfolio is at a 100+ year low. Both asset classes are expensive, leaving an investor little to work with in the way of portfolio building blocks. Worse yet is the should the mood of the markets darken, and thus mute the potential benefits of diversification.