Risk comes from not knowing what you’re doing. – Warren Buffett

One could argue that the reason Bernie Madoff was able to con so many investors for so long was that he was giving them exactly what they wanted.  What they wanted were positive returns, albeit not outsized returns, month in and month out.   According to reports this worked out to, on an annualized basis, 10 to 12% returns.  These returns must have looked especially attractive during the past decade when the stock market was a breakeven proposition.

Bernie Madoff is in prison, but we are still collectively coming to terms with idea that we are entitled to these very same returns from the stock market.  The decades of the 1980s and 90s taught us that the stock market goes up 10%+ a year on average.  Sure there were bumps along the way like 1987 and 1990.  But on average the stock market (and bond market) were hospitable places during this time period.  Despite a market crash, the stock market ended up for the calendar year 1987.

Source:  StockCharts.com

The capital market were such a hospitable place during this time period that investors became ever more comfortable holding risky assets in various collective vehicles like mutual funds.  Self-directed vehicles like IRAs and employee-based plans like 401(k) plans became common things.

One can see from the above chart of the S&P 500 that the current decade has seen something altogether different.  Rather than seeing steady, positive returns from equities we have experienced the worst of both possible worlds:  low returns and notable volatility.  Some have argued that the woes of this decade have been due in part to a “shortage of safe assets.”  In any event, the timing is ironic in that the investment world is now more hospitable to individual investors than it has ever been (leaving aside the issue of high-frequency trading for now).

The ironic thing is that at a time of poor returns, the information and tools available for investors have improved dramatically.  This is largely a function of the rise of Internet.  Abundant data, cheap trades and an explosion in investment vehicles, i.e. ETFs, have made it ever more possible for individuals to manage their portfolios how the largest institutions did just a few years prior.

Even with these tools it is not clear that we can achieve Madoff-like returns.  Felix Salmon at Reuters wrote the topic of trying to hedge so-called “tail risks.”  Asking whether there is a way to offset the risks of extreme outlier events.  His answer being that there is no easy, magic bullet available to investors. Salmon writes:

Ultimately, tail risk is something that’s very expensive to hedge, and attempting to do so might well fail. It’s worth thinking about, but some things, while great in theory, just don’t work so well in practice. And I don’t think there are any tried-and-tested tail-risk hedging strategies.

Some others have weighed in on this topic as well including Roger Nusbaum and Jared Woodard both weighed in the topic.  While they came at it from different perspective both find more evidence for risk reduction, albeit through a more active trading approach to risk management.  This approach by design is risk averse in that it looks to offset some of these downside risks.  This approach is similar to one advanced at the Pragmatic Capitalism blog that compares investing and baseball:

While hitting home runs is sexy it is rarely a recipe for success in the investment world.  Aim high, but play small.  Over time, good risk management and patience wins.  Power is no substitute for precision and patience.  The same is true in the world of investing.

Eddy Elfenbein at Crossing Wall Street has a post up that talks about the democratization of investing and how it is an inherently risk proposition in which individuals will oftentimes make the wrong decision.

The stock market is a great place to invest but its inherent volatility is extreme for smaller investors. The Dow went nowhere from the mid-1960s until the early 1980s, plus an ugly bear market from 2000 to early 2009—that’s a huge part of a person’s post-retirement lifetime. A millionaire can handle it, but it’s very painful for younger investors.

Matthew Yglesias frames this issue in terms of a public policy question.  He asks whether we have democratized investing too much by pushing down decision making onto individuals in subsidized savings/investment vehicles like 401(k)s.  While there has been some attempt to enhance education for employee-investors there is little doubt that most investors still feel at sea in making these types of decisions.  Some might argue that we can mitigate certain investor errors by putting their investments on “auto-pilot.”  However this approach derived from behavioral economics risks glossing over the risks inherent in investing.

The bottom line is that there is no way to snap our fingers and return back to a time when investing was in a certain sense easy.  Smooth, double-digit returns gloss over the many mistakes investors make.  What is clear is that many have not given up their sense of entitlement.  This new environment asks more of investors (and advisors), both in terms of education and activity.

Nearly everyone recognizes that investing in a privately held business is a risky proposition.  Entrepreneurship is a well-recognized path to wealth, but is at best an uncertain one.  Maybe investors of all kinds should have the exactly same mentality when it comes to investing in the capital markets as well.  Unfortunately for those unwilling to take those kind of risks an unremarkable return on safe assets awaits.

The Warren Buffet quote from the beginning of this post is in a certain sense a necessary, but not sufficient, requirement for investors.  Investors of all stripes need to “know what they are doing.”  Unfortunately this not sufficient to generate notable returns in a more inhospitable environment.

There may be ways to mitigate the risks of investing in risky asset classes, but we cannot eliminate risk without paying too high a price.  The markets of the 21st century have been a far cry from the last two decades of the 20th century.  The one bright spot now being that individuals now have the tools to truly customize their own investment approach.  It is ironic that the markets are now at their most democratic at time when returns are at their nadir.

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