What we watch on television, what websites we visit and how effective processes are at work — metrics are used in every facet of our lives and support how capital is deployed across differing investment opportunities. So what happens when the wrong metrics are used? Let’s explore the investment management industry to expand on this.
Investment risk metrics are a component of the overall investment decision making process. Within the financial markets there is the tendency to allocate capital using a process that incorporates standard risk metrics that others, primarily in academia, have developed — think volatility metrics — that makes little sense to many long-term focused investors. Even though these metrics may not be a good fit they are still widely used to compare the risk-adjusted performance of product offerings across investment management firms. Independent thought and logic should lead an allocator of capital to realize that different metrics should be used based on the particular situation under analysis instead of broadly accepting industry standards as acceptable.
Taking a Closer Look
Mainstream quantitative methods calculate risk as a function of the historic oscillations of the market prices of stocks. Meaning, the risk of an asset traded on public markets is determined by the past investment decisions of active buyers and sellers in the marketplace. This measurement does not reflect the product of primary research performed to assess the intrinsic value of an asset. Instead, the assumption is made that markets operate efficiently, that buyers and sellers act rationally based on all available public information, and this affords market participants the opportunity to capture the risk of an asset e.g. stock, indirectly without necessarily having to know much at all regarding the operations of the underlying business. Makes sense…right? Allow me to explain differently. Risk is measured by what other people, who you don’t know, have done in the past for reasons that you are likely to never know.
Question: What does it mean when no new information is made public for a company and people are still buying and selling, pushing a stock price up and down?
Answer: Investors buy and sell for a variety of reasons that may have nothing to do with the underlying value of a business because in many cases a manager may not be concerned with the underlying operating assets of a business. Think market technicians. So the buying and selling of a stock may be largely driven by traders who are only looking to capitalize on psychological characteristics of other market participants within the same stock, not concerning themselves about the details of the underlying business that a ticker symbol may represent.
Now, let’s say there is new information released about a company. For example, a company has decided to stop paying dividends, and since the announcement the volatility of the stock has increased. In this example, let’s assume the shareholder base rotated since many of the original fund managers coveted the stock because their clients crave dividend issuers as a source of current income. Should the volatility generated by the rotation of a shareholder base be considered risk? What if the reason the company planned to stop the dividend payments was to buy back shares of their own stock, and that this was a far superior and tax efficient way of allocating capital in your opinion? The risk profile to you has decreased, while for others, the risk profile has increased as investors spend the next couple of weeks buying and selling shares to reposition their portfolios after the news.
When fear, born out of concern for increased volatility, begins to infect an investment you own and there is no news that is substantively negative that would affect the operating future of the underlying business, shouldn’t you buy more shares? This simple concept, often discussed, that is so easy to understand and yet so incredibly difficult and counter-intuitive to implement can elevate an average long-term investment performance to a great long-term performance by a disciplined investor. The cost of accepting predefined metrics that are widely used within any industry may be professionally acceptable, but the long-term costs of lost independent thought can have profound financial consequences.
Cyrus Amin is a managing member of C. Michael Amin LLC.