In this quote, legendary investor Howard Marks emphasizes the unpredictability of markets and the importance of preparation, which includes understanding and accounting for risk.

In investing one of the most underappreciated elements of a successful portfolio approach is properly assessing the risk profile of key asset classes. Capital markets are not static and are sometimes heavily influenced by investor sentiment. This is especially true over the short term.

In the ever-fluctuating realm of financial markets, the volatility index (VIX) and other risk assessment tools serve as vital barometers for investors' sentiment toward risk.

This phenomenon, often referred to as market complacency, signals a period where a prevailing sense of investor overconfidence overshadows the potential for risk.

Such periods of perceived stability can be misleading, leading investors to adopt more aggressive portfolio allocations in pursuit of high returns, inadvertently exposing themselves to higher risk.

The allure of lucrative returns can often cloud judgment, making it essential to understand the dangers inherent in not properly pricing risk, especially when indicators suggest that risk may be underpriced.

This underpricing of risk, or overexuberance, can lead to significant market corrections when the actual risk materializes, impacting investors who may not be prepared for sudden shifts in market dynamics.

In this note, we delve into the critical importance of accurately pricing risk, exploring the consequences of market overexuberance and the subsequent implications for investment strategies.

Additionally, we will introduce our Risk Aversion Index (RAI), a unique tool designed to offer a comprehensive view of the investment landscape, helping investors navigate periods of under or overconfidence with greater insight.

By examining the construction of the RAI through its five distinct buckets—differences in asset class performance, asset class volatility, the shape of the yield curve, credit spreads, inflationary expectations, and the health of the economy—we aim to provide a clearer understanding of the current investing environment.

This analysis is not intended as a timing tool for market entry or exit but rather as a means to describe the investing climate, offering valuable insights into the collective mindset of the market's participants.

As we explore the nuances of risk underpricing and the utility of the RAI, our goal is to equip readers with the knowledge to make more informed decisions, ensuring their investment strategies are aligned with a holistic understanding of market conditions and potential risks.

Understanding the Danger of Underpricing Risk

In the tranquil waters of today’s investment landscape, where the VIX and similar indices sit at historically low levels, there lies a deceptive undercurrent of risk underpricing.

This phenomenon can lead to a false sense of security among investors, driving them towards increasingly aggressive investment behaviors without a proportional appreciation for the risks involved.

The danger here is twofold: not only does it heighten the potential for significant financial losses, but it also undermines the foundational principles of prudent investment management.

Real-World Examples of Risk Being Underpriced in Financial Markets

The Dot-Com Bubble (Late 1990s - Early 2000s):

One of the most vivid examples of risk underpricing occurred during the late 1990s, as investors, caught up in the exuberance of the burgeoning internet sector, poured money into dot-com companies.

Many of these companies, despite lacking solid business models or even revenue, saw their stock prices soar on sheer speculation.

The bubble burst in the early 2000s, leading to a massive market correction and significant financial losses for investors who had underestimated the inherent risks of these speculative investments.

The Subprime Mortgage Crisis (2007-2008):

The financial crisis of 2007-2008 serves as a stark reminder of the dangers of underestimating risk, particularly in the housing market.

Financial institutions and investors significantly underpriced the risk associated with subprime mortgages, leading to a widespread issuance of mortgage-backed securities and collateralized debt obligations based on these risky loans. When the housing market collapsed, the ripple effects were felt worldwide, resulting in the global financial crisis.

The European Sovereign Debt Crisis (2010-2012):

The European sovereign debt crisis highlighted how underpricing risk could lead to significant issues on an international scale.

Investors initially overlooked the varying degrees of credit risk associated with bonds issued by different Eurozone countries, leading to artificially low borrowing costs for nations with weaker economies such as Greece and Cyprus.

As the true extent of the risk became apparent, several Eurozone countries faced severe financial distress, requiring international bailouts to prevent default.

These examples underscore the critical importance of accurately pricing risk in investment decisions.

They demonstrate how periods of market exuberance can lead to significant financial downturns when the underlying risks are not properly accounted for.

For investors, these historical events highlight the value of tools like the Risk Aversion Index (RAI), which can provide a more nuanced understanding of the investment climate and help avoid the pitfalls of underpricing risk.

The Role of Quantitative Easing in Risk Perception

In the post-2008 era, central banks around the world embarked on unprecedented quantitative easing (QE) programs, injecting liquidity into the financial system to stimulate economic growth.

While these measures were crucial for recovery, they also led to concerns about underpricing risk.

The same situation arose during the COVID-19 global crisis.

The abundance of cheap money encouraged investors to seek higher returns in riskier assets, potentially overlooking the inherent risks associated with these investments.

While monetary policy is not nearly as stimulative as during the Financial Crisis or the COVID-19 days central banks around the world are not nearly as conservative as during previous generations.

For illustration purposes, look at the balance sheet of the US Federal Reserve. The expansion in assets after the 2008 Financial Crisis looks like a mere blip compared to what happened during COVID-19.

Monetary authorities in the US and abroad have been reluctant to take the punch bowl away which in my opinion has contributed to an under-appreciation of risk in the financial markets.

The Role of the Risk Aversion Index (RAI)

Our proprietary Risk Aversion Index (RAI) serves as a critical tool in this regard. By providing a nuanced view of the investing environment, the RAI helps investors recognize when confidence in the market may be leading to an underestimation of risk.

It encourages a more disciplined approach to investment, reminding us that true success in the markets is not about capturing the highest returns at any cost but achieving sustainable growth through careful risk management.

The Five-Bucket Approach to Measuring Market Sentiment

In the landscape of investment tools designed to gauge market sentiment and risk, our proprietary Risk Aversion Index (RAI) stands out for its holistic approach.

Recognizing the multifaceted nature of market dynamics, the RAI incorporates a comprehensive array of indicators, grouped into five distinct buckets.

• Differences in Asset Class Performance: This bucket compares the performance of various asset classes, revealing shifts in investor preference and risk appetite. A move towards traditionally safer assets like bonds over stocks may indicate rising risk aversion among investors.

• Asset Class Volatility: By examining volatility within specific asset classes, investors can gain insights into market uncertainty and the potential for price swings. Increased volatility often signals heightened market nervousness.

• Shape of the Yield Curve: The yield curve, representing the interest rates of bonds of different maturities, is a trusted economic indicator. An inverted yield curve, where short-term rates exceed long-term rates, has historically been a precursor to economic recessions, highlighting investor pessimism.

• Credit Spreads: The difference in yield between corporate bonds and government securities of the same maturity. Wider spreads suggest that investors are demanding higher returns for riskier investments, indicating concerns about corporate health and economic stability.

• Inflationary Expectations and the Health of the Economy: By assessing expectations for inflation and economic indicators, this bucket gauges investor sentiment regarding future economic growth. Rising inflation expectations or weakening economic indicators can point to increased investor caution.

Methodology:

We use a variety of market and economic data in each bucket and use a proprietary weighting scheme to arrive at a combined score.

We then recalibrate the combined score relative to its history up to that point in time to arrive at the daily RAI score.

The starting point of our data is 2003 and we re-estimate the RIA daily. Because daily readings can be volatile we smooth the scores using a 5-day moving average.

Based on the recalibrated RAI score we assign the score to one of three categories:

Implications:

When the RAI is in the Normal Zone, investors are generally aware of the risk of key asset classes.

This is a no-action zone. Things from a risk perspective are in balance.

When the RIA is in the Fear Zone, asset class risk is generally high relative to historical norms. Correlations among equity asset classes (Large, Small, Intl, and Emerging) typically jump up lessening the value of diversification.

The correlation of fixed income to equities tends to decrease but not typically enough to offset the loss of diversification benefits in the other asset classes.

When the RIA is in the Exuberant Zone, asset class risk is typically low and trending down relative to history. Prices on the other hand are trending up resulting in investor complacency.

Typically, there are one or two dominant asset classes in the early stages of being in this risk zone, but the rally then extends to every other asset class.

What is the RAI saying right now?

After a long time in the Exuberant Zone (starting November 24, 2023), the RAI recently moved into the low end of the Neutral or Normal Zone driven primarily by a recognition that inflationary forces are still high and that the Federal Reserve is unlikely to lower rates before there is more evidence of a slower economy and a steadily declining inflation rate.

Given today’s (April 10) consumer inflation report which came in above expectations, the likelihood of a rate cut anytime soon is quite low. I expect that we’ll be in a more normal risk environment for the foreseeable future.

Investors accustomed to the low volatility we’ve been experiencing since November will feel uneasy but markets tend to function best when there is a healthy respect for risk amongst investors.

Unless things get out of hand in terms of a sudden dive into an economic recession or another upward spurt in inflation I expect normal levels of capital market volatility and investor sentiment to remain balanced.

 Current Reading: Normal

Recommendation:

We have just emerged from a period of low asset class volatility breeding investor complacency. The key to navigating periods of underpriced risk is a balanced and risk-adjusted investment strategy.

Sure there will be times when you feel like you’re leaving money on the table by holding asset classes such as bonds or real estate that typically lag during exuberant markets, but the temptation to go all in on what’s working currently (US Large Cap) is not a winning recipe.

Diversification, careful asset selection, and a keen awareness of market indicators, like the VIX and RAI, can help investors guard against the temptations of overexuberance.

Given the current RAI reading in the Normal Zone:

• If you have been diligent in rebalancing your portfolio and your allocation is well diversified across all major asset classes chances are that your portfolio is well positioned and no further action is needed.

• If you got complacent and let your portfolio drift toward the higher performing, riskier asset classes your next step is to re-balance toward a more balanced, risk-aware set of portfolio holdings. There is still time. You will likely end up buying some fixed income and selling some of your equity holdings.

In any case, it is also essential to regularly review and adjust portfolios in response to changing market conditions, ensuring that risk levels remain aligned with individual financial goals and risk tolerance. Understanding investor sentiment is an often under-appreciated aspect of managing your money.

The RAI's Role in Investment Decision-Making

The RAI is designed not as a crystal ball to predict market movements but as a barometer to measure the current investing climate.

By offering a detailed view of the market through these five lenses, the RAI aids investors in understanding whether the capital markets are displaying signs of overconfidence or undue caution.

• In periods where the RAI indicates a possible underestimation of risk, investors are encouraged to reevaluate their portfolios, potentially reducing exposure to high-risk assets or increasing diversification.

• Conversely, when the RAI suggests that the market may be overly pessimistic, it might be an opportune time to consider investments that could benefit from a market rebound.

The introduction of the RAI into an investor’s toolkit enhances the ability to make informed decisions.

By dissecting the market into comprehensible segments, it sheds light on the underlying sentiments driving market movements.

This level of insight is invaluable, particularly in an era where market conditions can change rapidly, and the cost of complacency can be high.

The phenomenon of underpricing risk in financial markets is not new, yet it remains a pertinent issue for today's investors.

Historical examples, such as the dot-com bubble, the subprime mortgage crisis, and the European sovereign debt crisis, offer valuable lessons on the consequences of market overexuberance and the critical importance of accurately assessing risk. These events serve as cautionary tales, reminding us that the cost of complacency can be devastating.

According to our Risk Aversion Index (RAI), investor sentiment has only recently turned Neutral after spending a long time in the Exuberant Zone.

Traditional risk indicators like the VIX and the RAI had been suggesting low perceived risk but in reality, risk was simply being under-priced.

In periods of calm, investors must remain vigilant. It is tempting to chase higher returns in a low-volatility environment, but doing so without a proper understanding of the risks involved can lead to significant financial setbacks.

The key to successful investing in any market condition is a balanced and rsk-aware approach. Here are a few strategies investors can employ to navigate the waters of market complacency:

Asset Allocation Performance Review

High-Level Observations:

• All asset allocation portfolios we monitor are up year-to-date with higher-risk portfolios exhibiting commensurate higher returns.

• Conservative portfolios with a heavier allocation to bonds are still recovering from the 2022 capital market collapse but the trend is up. Over the last three years, the GF Low-Risk strategy is only up 1.6% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.7%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities. The GF High-Risk strategy is up 3.7% on an annualized pre-cost basis over the last three years. Over the last 5 years, the strategy is up a respectable 7.6%.

• Year to date, commodities have provided a nice boost. A big reason is higher oil prices. Most recently, precious metal prices have joined the party providing a further boost.

• International fixed income remains a disappointing asset class for IUS investors. Yields are lower than in the US and the unexpected strength of the US dollar has resulted in negative performance.

Weekly Performance Attribution

Long-Term Asset Allocation Portfolio Characteristics

Expected Returns:

Risk:

Equity Risk:

A Bit of Humor Never Hurts

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