Successful investing is about weighing projected risk and reward. When the opportunity set of available investments is artificially distorted, this job becomes extremely difficult. Such is the case now, with short-term rates being held at near zero levels, resulting in little to no reward for holding short-term, traditionally low-risk investments such as T-Bills, CDs and money market funds. To have any hope for a positive return (before inflation), an investor in today’s market must be willing to assume risk. But does that make it a good idea?
When Federal Reserve Chairman Ben Bernanke announced the program to purchase treasury securities last year, he stated one of the objectives was to raise the prices of other financial assets (stocks, bonds, etc.) beyond the levels they would otherwise be. Holding short-term interest rates at near-zero levels has the same effect, leading investors to takes risks they otherwise would shun.
However, while tempting, a lack of attractive alternatives is not a reason to accept investment risk. Today, as always, the overall level of risk an investor assumes should be determined by his or her time horizon, objectives, financial situation, and available opportunities. When evaluating these opportunities, it is also important to consider valuations of the various investment classes (stocks, bonds, real estate, commodities, alternatives) being examined.
Value is the intrinsic worth of an asset based on underlying fundamentals. In the case of financial assets such as stocks, valuation is determined by the stream of future cash flows expected to be generated from the investment. Paying attention to valuation means increasing exposure to risky investments when valuations and projected returns are attractive, and paring back exposure as valuations become stretched and projected returns decline. Some call this market timing. Others prefer to think of it as a prudent and responsible way to manage and protect capital, and generate long-term returns.
Unlike the 80’s and 90’s, the past decade has not been kind to investors. Excessive debt, the housing/credit crisis, and slowing economic growth (all of which are related) have coincided with near-zero returns over the past decade.
However, the severity of this sub-par performance owes to the fact that we began the decade (2000) with excessively high and unsustainable valuations. In other words, returns since 2000 have been poor in large part because stock prices began the decade at such a high level. In fact, if we had begun the decade at an historic “fair” valuation, the average return for the decade would have been around 8-9% - near its average and far from a “lost decade."
John W. Pfenenger II, CFA, is the President of Prism Capital Management, LLC. He has over 20 years of experience in investment management, research, and consulting. John can be reached at johnp@prismcapm.com
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