Good reads from around the Web.

This week we’ll see the Chancellor deliver another uninspiring budget. Everyone knows the economic figures will be bad, and nobody knows what to do about it. (Certainly far more unites our political parties than divides them).

My early optimism in 2010 about a return to growth in the UK turned out to be wildly misplaced (although happily it hasn’t retarded the UK stock market).

Like most people I underestimated how long the global crisis would drag on for – we haven’t seen the likes of this for 60 years. And while I knew UK consumers were living according to precepts of Brewster’s Millions, I didn’t appreciate just how ruinously this dovetailed (IMHO) with excessive state spending to produce a double-whammy of living beyond our means. Now we’re catching up with reality.

I used to think the Coalition government was making the best of a bad hand, but I’ve now concluded they’re simply way out of their depth in facing this challenge.

We all have our own opinions about why most politicians are now basically PR men and self-confident ex-public schoolboys largely untested in the real world. Personally I think the electorate must take most of the blame.

For example, I was rooting for Obama not Romney in the recent US elections, but you only have to see how the latter was vilified for his infamous 47% comment to understand that free debate is toxic in modern politics.

Better than nothing

In any event, there’s no evidence we’ll see anything bold from this lot. Even the things they’ve got right they’ve inched towards half-heartedly, and they’ve embraced stealth taxes to boot.

Being bolder would have at least been good for our animal spirits. I’d have raised the £10,000 personal allowance at a stroke, for example, which would have raised real incomes for the poorest, sent a clear signal about rewarding work, and delivered a boost for the economy.

I’d have been cleverer on spending, too.

I don’t apologize for seeing the need to make many of the cuts the government has started to make. State spending and a growing entitlement culture needed curbing in my view, even without the gigantic IOU left by the financial crisis.

But I’d have offset at least some of these cuts with targeted infrastructure spending. Now is the time for the government to borrow a few billion at today’s bargain rates to build a new town or two in the South East, for instance. Damming the Severn Estuary to create a massive hydroelectric resource would have been another capital spending project I’d have put into place. There are others.

I understand infrastructural spending has a mixed record, but in my view it’d be great for morale. And even if we end up slightly down on the deal in fiscal terms, at least a few hundred thousand young people would have been employed and would have had a better chance of one day owning a home. And there would be slightly less need for fossil fuels in the future, too.

Fiddling while Romford burns

Big bold actions like radical tax reform – say an across-the-board flat rate tax of 30% and all exemptions out the window – are unthinkable with these leaders.

Instead we’ll get more tinkering.

On that note, be especially alert to talk of changing the Bank of England’s inflation remit. The Bank’s own chief economist Spencer Dale warned as much this week in The Telegraph:

The lesson from history has been the best a central bank can offer for “a prosperous and vibrant economy was to deliver enduring price stability”, Dale said.

“Recently, there have been some worrying signs that cracks may be appearing in that consensus. A sense that inflation is somehow yesterday’s war. That central banks should focus more on growth. That a period of higher inflation may even aid the recovery. This is dangerous talk.”

Citing the experience of the late 1960s when policymakers let “inflation to get out of control after nearly two decades of price stability”, he cautioned against being “complacent about the risks posed by further stimulus”.

He added: “It would be irresponsible to repeat the same mistakes again.”

Dale is right to warn on this.

Today we find ourselves with political leaders who have never aspired to be much else. That means in my view that solving our problems via higher inflation – even if it means overall we’re worse off than we might have been – is an  appealing option, because the electorate doesn’t understand the real value of money.

Of course we could argue that politicians don’t, either.

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One of the side effects of using the word risk in investment is the connotations of bravery, cowardice, and going for glory.

Loading your investing decisions with such emotional baggage is about as healthy as loading your potato skins with cheese, bacon, and sour cream.

It’s not as if risk even has a precise meaning in everyday use. Risk is very different if we’re talking about taking a shortcut down a dark alley to the supermarket, a paratrooper going out on patrol in Afghanistan, or Warren Buffett spending $20 billion to buy a company.

I’m notoriously risk-averse in real-life. I emailed friends in vindication when the horsemeat scandal broke, since they’d all suffered from my pickiness about food. ¹ I’m not exactly the first one through the doors of a dodgy pub in a foreign city, and I avoid winter sports for the same reason Dustin Hoffman avoids flying in Rainman.

Yet when investing, my risk tolerance is as high as anyone I know.

True, everyone takes risks when they invest. I’ve one friend who shuns shares except for periodic punts on tech companies, and others who keep all their money in cash.

My first friend risks losing his entire investment – though not everything as most of his money is elsewhere in a business.

The second group risks losing the lot to inflation.

I believe my diversified, equity-denominated portfolio is far less risky and potentially more rewarding. Yet my co-blogger The Accumulator quails if I tell him I’ve put a five-figure sum into a small cap property company.

For him it’s the risks of lagging the return from the market and losing out in trading costs that loom largest.

You call that a reward?

Even the flipside of risk – reward – means different things to different people.

My share-punting friend says he wouldn’t get out of bed for 6% real returns a year. He’d rather re-invest in his business. A reward for him, rightly or wrongly, is something that moves the dial now, not in 20 years time.

In contrast, I see him putting too many eggs in one basket.

My risk-averse mother isn’t fussed her portfolio of investment trusts increased its dividend payout last year. But she was excited when I told her the portfolio value had risen by so many thousands of pounds – even though the shares were bought for income, she many never sell them, and I’ve warned her they could as easily go down as up.

At the far end of the spectrum, the soldier in a warzone may be rewarded for putting his body armour on. He might only lose a leg, not his life.

Because you’re worth it

Risk, then, is a personal thing. You say to-may-to, I say tomato, you say banana, I see a banana skin.

This may seem obvious, but in my experience it’s not.

I was recently challenged in the comments on Monevator because I said pound-cost averaging a lump sum into the market was a sensible strategy for some people, if it reduced the chances of them losing a great deal of their new money in a sudden crash and they couldn’t emotionally take it.

The counter-argument was that over most periods, investing a lump sum immediately has delivered a higher return. Pound cost averaging was therefore “irrational”, and I should try to get people to see that.

But I don’t think it is always irrational.

Many people would happily take 5% returns over 20 years instead of 6%, if it meant a much smaller chance of losing 30% in any one year.

Certainly people should know the risks and rewards of their choices. However the decisions they make are not irrational just because they have an emotional component – and certainly not just because they reduce the potential return.

To say otherwise is to look at only one side of the equation – like speeding without considering the chances of a crash (or a divorce and a spell in jail!)

Even financial advisors have my sympathy when it comes to advising clients about risk.

What a terrible job!

Most people are more risk-averse than they think, and hate losing money. Whereas gains they shrug off as the natural order of things.

Yet few people go to a financial advisor to hear how to make a fairly secure 3% real return a year.

The crying game

Unfortunately, even if you agree that risk taking is a matter of personal choice, it’s difficult to judge your own tolerance ahead of a market crash, a recession, losing your job, or whatever else life throws at you.

(We’ll ignore the ‘upside’ problem of your returns being much higher than you expected. That’s only a drawback in the world of academics!)

You might vow to regard risk as just as important as reward, and choose an appropriate portfolio. But that’s a rational decision, not an emotion, and we’re emotional creatures.

The danger is that when the shares hit the fan, your emotions will take over, with damaging results.

Education can help. You might know you’re very afraid of losing money, say, but you’re convinced by the historical return from shares. So you could read all about previous stock market cycles to prepare mentally, and maybe begin trickling a small amount of money into shares over the next few years to get started.

The snag is we only live once. Take too long getting comfortable with risk and you might not have enough time to get a reward.

Worse, even a decade of experimenting might not tell you much. Plenty of investors in the 1990s felt very confident about shares. Only the thought of missing out on the biggest gainers bothered them! Then two bear markets in a decade slammed them for six.

Equally, some people seem wired for silly risk taking. Las Vegas exists because such people will always shrug off losses to try to make back their money.

My share-punting friend will probably never change. The best I can do is encourage him to lock some regular savings away in a pension fund, and hope he doesn’t learn about self-managed SIPPS!

How to explore your own risk tolerance

Here are some ways to better understand your own attitude towards risk.

Discover what others do

Read up on rules of thumb about risk, returns, and asset allocation. They’re not perfect but they are time-tested. Generations of investors have seen their fortunes ebb and flow, and these rules are the collective folk wisdom that’s been left when the tide’s gone out.

Stress test your portfolio

Instead of exclaiming, “What are the chances of that!” when someone says your portfolio is too risky, use a Monte Carlo simulator to find out. Is it worth a 10% chance of having no money at 75 for a 2% chance of having a maximum gain of £3 million, instead of £2 million? I’d suggest not.

Visualise the consequences

Look at photos of your parents when they were young, and again when they’re old. We have trouble imagining ourselves in our old age – but in most cases that’s who you’re taking risks for.

Try our risk tool

Experiment with the new risk tool here on Monevator, developed by the boffins at Which? It asks how much you’re prepared to lose in a year, and suggests different portfolios as a result. (I wouldn’t fuss over the exact asset allocations it suggests – thinking about the potential payoffs is the idea here).

Now none of these methods can really tell you how it feels to lose half your pension the year before you retired because you stayed 100% in equities too long.

But working through them puts risk and reward into the spotlight where it belongs.

Tip: Consider all the risks when making investing decisions. The first reason to invest is inflation, which erodes the real value of your money even as its nominal value stays secure. Over the long-term, inflation could be a bigger risk than temporarily losing 20-30% of your money in a crash.

Search for the hero inside yourself

Outside of the City and Wall Street, investing is not about beating the rest. It is not a macho sport.

I’d guess my own risk tolerance is higher than perhaps 90% of Monevator readers, although I’m not sure all of the newer arrivals to the market know it. I’ve seen my net worth plunge faster than the Liberal Democrat vote at a local election and I know I can endure it. In contrast the last few years have been a nirvana for shares, and complacency is building.

But despite my own attitude to risk, you won’t find me berating you for keeping 50% of your funds in cash, let alone for paying down your mortgage instead of gearing up to invest in shares.

Risk comes down to your own circumstances, goals, and your own gut feeling. Don’t take the risk of anybody convincing you otherwise.

1. I don’t think eating horse is bad for you – I think not knowing what you’re eating is.[↩]

Have you begun to fret that slow growth could stall your escape from work like custard in a jet engine? Then, like me, you’ve probably also wondered if there’s any way of speeding things up a little.

We’ve talked about saving more and spending less, and we know that jacking up your allocation to equities exposes you to greater risk. So now let’s consider an alternative approach: the potential to earn more from return premiums.

In the same way that we invest in the broad stock market over government bonds because we expect a greater return in exchange for the stomach acid (the equity return premium), certain types of equities may offer even higher returns as a ‘cheers, then’ for bearing risks beyond the market risk, or for exploiting persistent behavioural anomalies that seem rooted in human nature.

We’ll take a deeper dive into the expected return and diversification benefits of each premium in follow-up posts. For now, I’m just going to quickly map out the territory we’re exploring.

Also note the way I keep labouring the term expected return.

Although each return premium has been known to academics and investors for decades, there is no guarantee that the beneficial effects will continue to persist or offer the same froth on your returns as in days gone by.

Market risk – beta

The performance of the stock market obviously has an impact on most stocks. If the stock market tanks due to economic woes then it’s logical that the share price of a car manufacturer will fall too, as people buy less cars in a recession.

Beta is the measure of a stock’s riskiness ¹ in comparison to the overall stock market. If the stock market falls and a stock drops in lock-step then its beta is said to be 1.

If a stock is less sensitive to the movement of the market then it will have a beta of less than 1.

A utility company is an example of a low beta stock. People still need to keep the lights on when times are tough (so the share price is unlikely to swan-dive during a crash) but they don’t go all Jean Michel-Jarre when the green shoots show (hence the share price is sluggish when the market rises).

A high beta company ², conversely, amplifies stock market vibrations.

There is little argument about beta and we’d expect 70% of a diversified portfolio’s returns to come from this source, according to academic giants Fama and French.

But beta isn’t the only known return premium we can turn to. Several others have the potential to boost our rake, over the long term, if we overweight them in our portfolio…

Size

We’ll start with an easy one that you’ve probably heard of. Small companies (small caps) are inherently riskier than big companies (large caps) so investors demand higher expected returns to compensate.

A small cap firm may be:

• Gobbled up by a larger competitor.

• Ruined by misfortune (e.g. failure to secure a patent).

• Run into the ground by an idiot manager.

• Fall foul of any number of threats that a bigger company could ride out.

Size is measured by market capitalisation (market cap), but just how small is a small cap? Is it worth £1 billion? £500 million?

There is no consensus, but looser definitions tend to dilute the premium, which is already the weakest of the bunch.

Value

Value stocks are companies whose star is fading. While fast-moving growth companies wow investors with their uncoiling potential, value stocks have lost their lustre. They’ve taken some knocks and look like they’ll struggle in future.

Value companies are likely to have more:

• Debt.

• Dividend volatility.

• Earnings risk.

• Production capacity that’s hard to cut in a crisis.

Some academics believe the value premium persists because investors demand a greater return before they’ll risk taking on a potential basket-case.

Others believe that investors consistently undervalue weak-looking stocks.

Momentum

Momentum is the financial epitome of ‘everyone loves a winner’. It’s the effect of rising stocks continuing to rise and stuttering stocks being cast further into the pit of despair.

Momentum strategies work by buying recent winners and selling off the losers.

Human behaviour rather than risk is thought to explain the momentum premium. People tend to follow the herd and respond to news slowly rather than instantaneously.

Volatility

Portfolios consisting of low volatility (or low beta) stocks have been shown to deliver similar returns to the overall market but with up to 30% less risk.

Low volatility portfolios tend to go large on turgid stocks like utilities and non-durable goods while weeding out racy technology and manufacturing bets.

The upshot is that low vol strategies are resilient during times of trouble (see the beta section above) but underperform when markets sizzle. Over the long term, the low volatility premium flicks the Vs at the idea that you’ve got to choke down more risk to earn more reward.

Why should this be? Once again, investors are their own worst enemy, clamouring for the winning lottery ticket among high beta stocks no matter how unlikely it is that they’ll discover the next Google.

Liquidity

The liquidity premium is earned for taking on the risk of stocks (or bonds) that can’t be shifted in a hurry when you need to staunch a loss.

Yawning bid-offer spreads and low daily trading volumes are tell-tale signs of poor liquidity.

The liquidity factor is strong in small cap and value stocks. The premium increases during times of crisis as takers of less liquid stocks can charge an arm, a leg, and a kidney to desperate sellers.

Gross profitability

This premium is fresh out of the gate and makes hay from the seemingly bleeding obvious – namely that profitable firms produce significantly higher returns than unprofitable ones. Returns that are right up there with the value premium, and which may reveal that investors undervalue firms that are investing in jam tomorrow, not jam today.

Profitability latches on to a firm’s gross profits-to-assets ratio. It seeks to uncover firms whose products sell for much more than they cost, but whose raw quality may be masked because of high investment rates that lower their net earnings.

Essentially, these firms are investing a high proportion of their earnings in R&D to enable them to succeed in the future, but are penalised because they deny investors juicy earnings now.

Profitability tends to suffer less in downturns and is complementary to value.

Factor flirty

Other return premiums can wink in and out of existence but the factors above are widely recognised and haven’t yet been worn away by investors flocking to them like tourists up the steps of Machu Picchu.

So how can passive investors exploit return premiums? How big are they? How risky? How do I incorporate them into a risk-factor portfolio?

These are questions you can find the answers to by clicking on the links above.

Take it steady,

The Accumulator

1. Or a fund’s or a portfolio’s exposure to the market.[↩]
2. Where beta is greater than 1.[↩]