Where Fools Go

The potentially greatest single good the financial services industry could do for its clients is to make the critical distinction between ‘volatility’ and ‘risk’.  However, knowing this industry, we are not holding our breath that any offer of such education will be forthcoming soon.

Whatever the level  Dow Jones may be at the moment you read this email, we have every reason to know that volatility is the onset of a temporary decline – which happens all the time – whereas risk refers to the chance of a permanent loss.  In a well-diversified portfolio held for the long term, this permanent decline has historically never happened.  The difference in those terms, volatility and risk, is far more than a semantic discussion.  Frankly, it is the single largest reason a few investors prosper while most fail.

You would think that the managers of some of the largest portfolios in the world would know this distinction. Alas, looking at the endowment funds of some of the country’s most prestigious colleges, you would be wrong.  Take the Harvard University endowment fund.  In the five year period ending December 2013, the endowment fund earned 1.3% per year.[i]  As opposed to these intellectuals, the ‘dumber than a post’ Standard and Poor’s 500-Stock Index produced an average annual compound rate of total return over this same period of 17.91%[ii].  With a $30,000,000,000 size fund, we’re talking pretty big money here.  No surprise that the CEO of the University’s endowment fund is stepping down (with a salary of $4.8 million in 2012[iii], she was the fourth person to hold this job in the last nine years).

How could these lousy returns happen?  Because smart institutional investors were plunging head long into ‘alternative investments’.  These investments (known by such mystical names as “long-short funds”, “momentum plays”, “private equity”, “hedge funds”, etc.) WERE the rage in 2008 when the markets collapsed because, well, people just couldn’t handle the volatility anymore (there’s that word again).  Following the leader, the drug was so alluring that the average college endowment fund had something like 54% of its investments in ‘alternative investments’ as of the end of the 2013 academic year.  But the ‘rage’ is now a different kind; Foundation Trustees are now asking their endowment managers “How the heck did you so miserably under-perform?”

A similar diatribe could be leveled against this industry for pushing bonds over the past five years…or any ‘structured investment’ that involved bonds—as a way to pander to investors rather than looking volatility in the face.  In the most significant collapse in equities in 50 years, they let investors take the pain, but then benefit from none of the gain.  Why?  Because bonds were easy to sell – not right for the investor – but easy to sell.  In 2013, after equity markets have been steadily up for over four years, ONLY THEN do we see equity fund inflows[iv], and those flows being the strongest in 21 years![v]  Little late to the party, eh?  Further, in the search for yields when the Fed has pushed interest rates terribly low through its monetary policy and discount window, the sales of ‘high-yield bonds’ (junk bonds in industry parlance) has been unabated.  Make no mistake about it, interest rates are niggardly low and possibly hurting the average American far more than helping them (another whole topic), but we’re looking for yield in all the wrong places. The spread in high-yield bonds over Treasuries is far under its historical average, meaning people are chasing yield and again ignoring risk.  Interest rates WILL increase, but no different than the 2008 collapse in equities, that’s a simple ‘reversion to the mean’ prediction and thus requires no Ivy League rocket science.  People are going to get hurt.

We all want good returns, but cannot pander for the elixir of the moment.  In spite of this new pitch or that for relief, we must never mistake volatility for risk.  There are simply no happy endings in those stories.


[i] Nick Murray Interactive (“The Downward Spiral of Pandering”, August 2014)

[ii] ibid

[iii] “Harvard Seeks Fund Chief for the Long Haul” (Wall Street Journal, Online, June 23, 2014)

[iv] “The Tide Turns Toward Equities” (Morningstar Global Funds Flow Report, March 2014)

[v] FundFlows Insight Reports (Tom Roseen, Lipperweb.com, January 21, 2014)