In the financial world, the risk of a system-wide negative event, such as a nuclear war, is considered to be systematic risk. Unsystematic risk is the risk of a specific negative event affecting an investment position, like a factory fire. The former must be accepted as a possibility of life, however tiny the probability. The latter can be mitigated by owning a diversified portfolio of assets.
Conventional theory classifies systematic risk in terms of volatility, represented in the academic literature with the Greek letter beta. Many market participants behave as the theory might suggest, not because they believe in it or even know it, but because human nature leads them in that direction. Human instinct and academic theory arrive at the same incorrect conclusion: volatility equals risk. For those desiring sustained investment success in the real world, the valuable insight lies elsewhere.
Trading strategies and short-term thinking are encouraged by the ultra-liquid nature of our financial markets. High frequency trading, perpetually open markets, online retail brokerages and other such modern facilities make it easy to get in and out of positions. This is the root of most investment problems. Time horizon is the coloured lens through which all investors view the panoply of investment options. The colour of the lens makes all the difference to an investor’s perception of the world.
The short-term investor (and also the leveraged investor) is actually right about the way he looks at risk, given that he is a short-term investor. To him, volatility is risk. Worse still, it’s a risk he cannot control or anticipate. An investment position could move against him due to a completely unpredictable macro-economic event and the position’s fundamental drivers would have no time to produce a recovery. Or a large move in a leveraged position may completely wipe out a position even though the underlying asset may go on to do just fine. Investors respond with an emotion humans usually feel when confronted with large threats we cannot control: panic. This response by fellow market participants is not irrelevant to the long-term investor.
The long-term investor dismisses the notion of volatility as risk. His definition of risk is the probability of permanently losing a material portion of his capital over reasonably long periods of time. He is not threatened by short-term movements in asset prices. He is focused only on specific, capital-threatening risks that he can avoid, control for, or diversify away.
Thus we have two types of risk — volatility, and probability of permanent loss of capital — and their respective beholders. In a market with these two types of investors, the long-term investor has a distinct advantage. In down markets he uses volatility, and the short-term investor’s reaction to it, to enter fundamentally sound positions at attractive prices. In bull markets, the long-term investor can reverse the process by selling to short-term investors when the latter are focused on the flip side of volatility: expected returns (a.k.a. the temptation to make a quick buck). Some people call this strategy “time arbitrage” or “time-horizon arbitrage”.
At Shepherd’s Hill we definitely take the long view. We strongly recommend you do the same for at least a portion of your savings.
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