Do you underestimate risk?

Most people seem to think you, and even most experts, do.

Research the phrase on the internet, and the headlines leap off the screen. According to the stories, we underestimate women’s risk of having a heart attack, risks to our health from a stay in the hospital, risks to our environment from oil spills, risks to our business from cyberattacks, risks to our lives from tsunamis, and even risks to human existence!

There has been much talk since the election about making infrastructure investments of over a trillion dollars. Yet, it is noteworthy that the need for bridge construction is a classic case of underestimation of risk. Here, as in other infrastructure spending projects, spending the money wisely may be difficult. According to a new study published in the Journal of Infrastructure Systems, the current means of assessing bridges may underestimate their vulnerability.

This proved to be the case with the Pfeiffer Canyon Bridge, which I have crossed many times in my travels to Big Sur and one of my favorite restaurants, Nepenthe. The bridge collapsed last March after the return of heavy winter rains in California. It is not expected to reopen until September, costing local businesses many millions of dollars and hours of inconvenience for residents and tourists alike.

The problem is that bridges are assessed for risk on just a single measure. The current standard is simply how they would withstand a 100-year flood—that is, a streamflow with a 1% probability of being exceeded in any given year. Yet, current models suggest that bridges are at risk for many more reasons. In the study mentioned previously, of 35 bridge collapses, scientists found that only 13 were caused by 100-year flood conditions, while 22 resulted from entirely different reasons not accounted for by the current risk measurement.

We fall for this same tendency with regard to investing. We often act on a single measure, causing us to underestimate the risk at any given time. Usually, it is the current investment environment that leads us into this trap.

In an article in the Harvard Business Review entitled “3 Reasons You Underestimate Risk,” Srini Pillay, an executive coach and CEO of the NeuroBusiness Group, reports that the reasons for what he calls “risk blindness” are that reward often obscures risk, a failure to properly assess sunk costs, and future aversion. Simply put, this means that we often downplay risks when we are on a long winning streak, too often avoid thinking about losses, and many times are paralyzed by future unknowns.

The suggested ways to avoid these human tendencies are many. However, they can be summarized as simply looking outside one’s narrower perspective and seeking out more possible outcomes. This can often be best accomplished by testing one’s assumptions and the outcome of different scenarios.

This is exactly what quantitative analysis is all about. It attempts to test various factors present in the environment or that are anticipated to determine the best action in different economic times.

Today, most of the indicators we test are not indicating a bear market (a decline in stock indexes of 20% or more). At the same time, a lesser correction is certainly possible.

As veteran stock market strategist Sam Stovall writes, “The S&P 500 is entering into a historically challenging two-month stretch and the market is long overdue for a decline of 5%+.”

We have not had a 5% correction for almost a year, so it is understandable that even such a small decline may be unexpected by most investors. Investors may be blinded by Wall Street’s current winning ways and ignore the risk of a decline that is truly inevitable … eventually.

To understand that this is the case, one need only look at the expected volatility of two sectors of the economy: the vibrant Technology sector and the staid Utilities. Believe it or not, investors in the options market are signaling more concern over the volatility of Utilities than that of Technology stocks. This despite the fact that a single discouraging earnings report on a tech stock has sent the NASDAQ tumbling in the past.

Much of the current talk is of a single measure in the stock market: volatility. A number of experts point out that they fear the current low volatility is an indication of complacency among investors that could be preceding a market collapse. Such complacency is said to be indicative of an underestimation of risk by investors.

And it is true that volatility has been remarkably low, ranging from below 10 to just 16 on the so-called fear index (VIX). Normally, it is in the 20s.

Yet, quantitative analysis does not suggest that low volatility in itself is indicative of a bear market forecast. Normally, corrections, when they occur in a low-volatility scenario, do not exceed the 20% threshold required to be classified as a bear market. At worst, mid-teen declines have occurred. Forecasts based on a single indicator are rarely sufficient.

If the pundit’s concern is right, and a bear is on the way, their sole suggestion is to make sure your portfolio is diversified across many different asset classes. Yet, research shows that most asset classes fall together with stocks when a bear market begins. Only bonds and gold seem to provide any real diversification potential.

Additional diversification can, however, be achieved with dynamic, risk-managed strategies. These periodically monitor the market using many indicators that tests have shown mitigate or reverse the bear market losses. Building a portfolio of these defensive strategies is a good approach to avoiding falling victim to the very human tendency to underestimate risk.

As a dyed-in-the-wool trend follower, it is hard for me to ignore that the stock market just made all-time highs last Wednesday. But, of course, bear markets always start from such levels.

NASDAQ Monthly 18 year Chart 08/09/17

Still, I see little evidence that such a major decline is likely. Earnings and revenue reports continue to shine (although, I always cringe when the reports turn to retail store sales, as they will later this week). If current multiples are maintained, this tends to move stock prices higher. If not, it lowers multiples and makes stocks less overvalued, as is the case presently.

S&P 500 Trailing 12 Month P/E Ratio 08/09/17

What is concerning is that recent economic reports have disappointed. Yet, in the latest reports, two of the most influential, GDP and employment, have surprised to the upside. This is also supportive of future growth.

Setting aside the political risks that are seemingly always present, the biggest risk today seems to be the Federal Reserve moving too precipitously to increase interest rates. Is the present 40% indicated probability for another rate hike this year an indication of investors underestimating risk?

I don’t think so. The Fed seems more interested in figuring out a way to reduce its bond inventory, accumulated to stimulate the economy out of the financial crisis, than in hurrying to raise rates. Whether the bond market can absorb the bonds and whether the Fed will actually sell as opposed to maturing its way out of its inventory are more pressing questions.

I am concerned that seasonality does suggest some weakness as we progress into August and September. Still, as I have pointed out, such weakness is often muted in years when the S&P has already gained more than 10%.

On the subject of underestimating risk, some studies have found that people do so when they feel that they are in control. Yet, these same studies have found that such people usually believe they are more in control than they actually are.

In investing, the use of disciplined, quantitatively derived strategies is one way of avoiding these common human failings of overconfidence and optimism bias.

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