When the Roads Are Dangerous, Why Are Investors Accelerating?

 
Sean Peche, Founder and Portfolio Manager at Ranmore Fund Management examines why investors seem happy to accelerate into dangerous market conditions when most of us would instinctively slow down.
 

Drawing on a recent experience driving in hazardous weather, Sean uses a light-hearted analogy to ask a serious question: with stretched valuations, extreme market concentration and geopolitical uncertainty, why does so much money continue to flow into S&P 500 and broader market ETFs?
 
In the article, Sean looks at:
 
•     Why investors may be overlooking market risks in their pursuit of returns
•     The difference between relative and absolute risk, and why following the crowd doesn’t necessarily make investing safer
•     Why investors should pay closer attention to the risks their fund managers are taking, rather than returns alone
 

When the Roads Are Dangerous, Why Are Investors Accelerating?

 
By Sean Peche, Founder and Portfolio Manager, Ranmore Fund Management

The driving conditions were dangerous as we set off for the weekend in our hired car. I was driving on unfamiliar, busy roads, at night, in rain and fog, with warnings of wind, roadworks and a windscreen wiper on the “wrong” side…

Now, I’m a very cautious driver because I think about risk management most of the time. I regularly ask my Uber drivers to slow down in return for a larger tip, because the stats for slow driving are compelling: for every 10 mph increase in speed, the risk of dying in a crash doubles, even in normal conditions!

So that night, I drove in the slow lane, around 20 km/h below the speed limit, and didn’t care how many cars passed me. All I wanted was to travel safely. Better a few minutes late than “dead on time”, as the saying goes.

Driving slower in dangerous conditions is obvious to me, as I’m sure it is to most. But then why aren’t we doing that with our investments? Because we all know that the “conditions” out there are “dangerous”: extreme concentration, high valuations, US bond yields over 5%, high oil prices and multiple wars.

And yet Bloomberg tells me nearly $300bn has flowed into S&P 500/total-market ETFs this year! So it seems we’re not slowing down; we’re “accelerating into the turns”!

Maybe the approach is: “If everyone else is driving at full speed in dangerous conditions, I’d better join them. Don’t want to risk underperforming…” Except that driving fast in dangerous conditions is when accidents happen. And yes, we all want to outperform, but with how much risk?

Now, you get relative risk and absolute risk. If you’re driving as fast as everyone else, you’re taking no relative risk. But if everyone is driving at 150 km/h, you’re sure as heck taking massive absolute risk. Which risk do you want to assume?

At Ranmore, we focus on absolute risk because we don’t want to risk crashing. It’s no consolation to us if we all crash together.

If you’re wondering how much risk your fund manager is taking relative to the returns you’ve been receiving, take a closer look at your fund’s risk and performance data. Risk and return can be compared over various time periods to help investors understand how much risk has been taken to generate their returns. For absolute risk, you can look at measures such as drawdowns and negative capture ratios.

Drive carefully, it’s wet out there.