Risk is always present, and always changing, and always surprising. Some of today’s risks may end as false alarms. Meanwhile, what seems benign, perhaps even beneficial, can bite back tomorrow. So it goes in the money game. The challenge is a) understanding the unending dynamic; and b) managing portfolios accordingly by factoring in various risk scenarios and deciding if the price of a given risk looks attractive or not.
The first step is considering the default benchmark for everyone–a global mix of all the major asset classes weighted passively. The main question is how to adjust this mix to satisfy your particular risk tolerance, time horizon while factoring in any expectations for specific risk and return among the various components. Decades of financial economics tells us no less and this two-step foundation is the analytical focus of The Beta Investment Report.
A little strategic perspective, in other words, goes a long way. It begins with calculating the benchmark, our proprietary Global Market Index, which we report monthly on these digital pages (here, for example) as well as in our newsletter, albeit in greater detail for subscribers. In the long run, this what the average investor holds, which is one reason why we pay close attention to GMI’s fluctuations and ever-changing profile. The next step is evaluating the major components of GMI in terms of how expected return and risk in the near term differs, if at all, from the implied equilibrium outlook. It’s a messy business and so we proceed cautiously, but it’s an essential step on the road for the thousand-mile journey of second-guessing Mr. Market’s asset allocation.

Among the many factors that go into projecting risk premiums: surveying the potential for unusual hazards popping up in the foreseeable future. This is invariably a speculative affair, which means the possibility of misjudging the danger. That’s one reason why we’re usually reluctant to stray too far from GMI’s passive allocation without a compelling reason.
In any case, what are some of the potential risks bubbling at the moment that could become bigger problems down the road? Routinely asking the question and considering the possible outcomes is critical for strategic-minded investing, even if we can never be sure that our answers will be accurate forecasts. Nonetheless, it’s valuable to ask, What if? and then consider how the answer might help, or hurt, a particular asset class. With that in mind, here are a few topics that catch our eye at the moment that are worth monitoring. They are by no means the only potential gremlins in the global economy’s machine, but surely they’re worthy of inclusion on the short list of risks prowling about these days.
* China’s undervalued currency. The FT’s Martin Wolf hits the nail on the head today in his column warning of the potential blowback embedded in China’s “heavily managed exchange rate regime.” As he explains, “China’s managed exchange rate is shifting adjustment pressure on to other countries. This was disruptive before the crisis, but is now worse than that in this post-crisis period: some advanced countries, notably Canada, Japan, and the eurozone, have already seen big appreciations of their currencies. They are not alone.”
* Debt. The world is awash in red ink, much of it due to the liquidity injections of the past year. But a fair amount is also the legacy of aggressive spending over the past decade. The bill, however, is coming due now, and at a less than ideal point in the business cycle. The Dubai debt problem may mark the turning point for the worse. As Reuters reports today, the “Dubai debt concerns spread beyond Dubai World.”
* A possible change of some magnitude in the Federal Reserve’s mandate. This may or may not be productive, depending on the details. But at the moment one has to wonder if there’s a threat of politicizing monetary policy, a change that would be counterproductive. The only thing worse than an independent central bank making policy decisions with mere mortals is one that’s further burdened by the politicians sticking their ideas into the mix.
Are there other risks floating about? Absolutely. And there’ll be new ones tomorrow. The good news is that risk is also the source of return over and above the proverbial risk-free rate that’s available in short-term Treasury bills and the like. A managed, intelligent exposure to risk is the goal. But we can never forget that risk has the power to take as well as give. Fortunately, there are some basic strategies for minimizing risk’s potential for pain and maximizing its capacity for minting profits. One possibility is owning an investment portfolio resembling our Global Market Index. This portfolio will never be the top performer, but neither is it likely to be last. Some risks, at least, are manageable with minimal effort and cost.