Veteran investors–otherwise known as anyone who’s gotten burned at least once in the capital markets–are rightly skeptical when someone comes along and says they’ve got the money game figured out. Someone says that, or its equivalent, about once every three seconds these days.
The reasons for staying skeptical are no less legion. Suffice to say, the proof is in the pudding and so it’s no accident that there’s a huge spread between the number of people who claim to have the secret investing sauce and those who can point to some real-world evidence. With that in mind, you may want to take the following with a grain of salt as well. Your editor too is a card-carrying member of the mere mortals club.
We say that because even a judicious, enlightened approach to investment strategy (which, we humbly believe, is a label that applies to our approach to portfolio design) is laden with risks, both known and unknown. It’s the latter that potentially pose the biggest dangers.
As an example, first consider a known risk, such as shunning diversification. Whether it’s a particular asset class or a broad asset-allocation strategy, everyone knows (or should know) that concentration risk is easily avoided and so anyone who suffers at the hands of this particular demon probably hasn’t been paying attention to the last 50 years of financial research. That’s not to say that one should never, under any circumstances, move away from complete diversification. But at the very least, know what you’re getting into before jumping off the cliff.
Meanwhile, it’s the unknown risks that keep us awake at night. By definition, this class of hazards is mysterious, of course, although we have some clues about how they materialize. Exhibit A is the evolving nature of markets, including the relationships between asset classes. It’s all too easy to look back on history and draw tidy conclusions about how the capital and commodity markets interact with one another. But finance is not physics, and so yesterday’s iron laws can and do turn into something less, something more or something entirely unfamiliar by yesterday’s standards.
Two quick examples: 1) the relationship between the 10-year Treasury yield and commodities; and 2) the extraordinary jump in spreads between the overnight inter-bank lending rate and the Libor rate.