The term “investing” is a misnomer when it comes to managing money. It’s really a job of choosing a set of risk factors that will produce an expected result. Most folks don’t think in these terms, but the reality of “investing” boils down to a basic framework: select assets today on the assumption that a particular outcome will arrive tomorrow. The details, of course, matter, which is to say that not all assumptions are created equal. One that’s on the short list is the belief that reversion to the mean endures when it comes to returns. Buy low, sell high, as they say, because returns are always fluctuating. History exhibits a long and deep pool of empirical evidence for thinking that a mean-reverting process dominates price behavior in financial and commodity markets through time. Embracing this idea in real time, however, is devilishly difficult, which helps explain why so many investors find it tough to earn a satisfying return over one or more business cycles. The trap of buying high and selling low, in sum, is never far.
Behavioral issues, it’s fair to say, are constantly in play. When trailing returns are high, it’s tough to sell, in part because the world is celebrating over the asset in question and no one likes to leave a party when the cheering is at its loudest. It’s no easier to buy when the crowd expects only trouble for a given market and prices the relevant assets accordingly.
Reluctance to think that high/low returns will reverse is only natural. In fact, there’s no law that says that reversion to the mean will prevail the next time. We can outline all kinds of economic explanations and models that make a compelling case for thinking that this time won’t be different, but in the end we must make a leap of faith and so there’s a risk that we’ll be wrong.
A current example: emerging markets, which have fallen on hard times. The iShares MSCI Emerging Markets ETF (EEM), for instance, has a negative three-year annualized total return of 3.7% through March 4, according to Morningstar. Meantime, the US equity market–Vanguard Total Stock Market ETF (VTI)–has a handsome 15.1% gain. There are good reasons for thinking that these numbers reflect accurate forecasts and it’s not obvious that the tables are about to turn in a meaningful way anytime soon. But you can’t rule out a reversal in these profiles either. In truth, no one really knows.
On the other hand, there’s absolute certainty that US stocks are sitting on strong gains and emerging markets have lost money over the last three years. The hard wiring in our brains makes it easy to embrace those numbers while remaining skeptical that reversion to the mean will triumph over the next several years.
In short, there’s a risk that if you sell VTI and buy EEM, you’ll lose out on future profits in US stocks and suffer ongoing losses in emerging markets. It’s a question of value or momentum? Pick your risk factor.
Actually, that’s always a topical question for managing asset allocation, and across a spectrum of risk factors. Inevitably, some of our choices in such matters will be wrong at times. What’s an enlightened, strategic-minded investor to do? Fight fire with fire.
If risk factors are constantly in our face, and forever threatening our wealth, the only rationale response is one of managing the risks, starting with the usual suspects: diversifying across asset classes/risk factors and periodically rebalancing the mix. But here too there are no guarantees. Risk management can work if we hold a properly diversified portfolio across the major asset classes, for instance. But if there’s a system-wide meltdown—think 2008—this normally defensive technique may be of limited value.
Then again, you could apply an additional tail-risk strategy for protection against extreme events, although this can be costly over time if you’re not careful.
Overall, whatever problem the markets can throw our way can be managed in some degree. The real challenge is deciding which risk exposures are appropriate and how to manage those risks. But you can’t engineer risk away to nothing in a portfolio, at least not without incurring unbearable expenses. In the end, you can only earn a risk premium as the result of bearing risk and managing it in a way that suits your specific risk tolerance and return requirements. You may be in the habit of calling this investing, but that’s really just another behavioral risk.