Oct 22, 2014 Investment Opinion: Caution! Event risk is significant
Event risk, refers to the possible occurrence of a political, military, natural, or other event that is: 1) not normally encountered in the investment environment, 2) largely unpredictable as to timing or degree, and 3) will have a significant impact on the market as a whole, or one or more sectors or stocks.
Event risk does not refer to changes in interest changes, EPS revisions, disruptive product introductions, stock buyback announcements, etc. These are part of the day-today investment landscape.
Event risk is not the same as black swan risk. I define black swan events as almost totally unpredictable. A dead volcano erupts and takes out a major piece of infrastructure. While black swan risk is one kind of event risk, I generally use the term ‘event risk’ to mean low probability risks which are reasonably foreseeable possibilities, although not with certainty, and with little predictability as to time and severity. Event risk is always present but is usually sufficiently remote as not to be on investor’s minds.
An adverse event is one which will have a significant impact on world or regional commerce, and therefore on company earnings, and therefore on stock prices.
In my forty years in the investment business, event risk has never seemed higher. It is particularly high in the mid-east in general, and from ISIS in particular. Russian, Chinese, and Iranian adventurism carry the risks of inadvertent war and disruptive commerce blockages. Ebola containment also threatens commerce disruption.
An adverse event from any one of these may have a low probability of occurrence, but together, the probability of an occurrence among them seems much higher than normal. In fact, it feels to me like a commerce-disrupting event may be as likely as not over the next year or two.
Following an adverse event, investors typically shoot first and aim later, i.e. sell stock, and then begin to assess the degree of damage to future earnings, cash flows, etc. In the near-term, stock price valuation means little. Panic selling, shorting, and forced margin selling can take the market lower than reasonable valuation models suggest. Valuation in the short run means little, but not nothing. Your judgment on valuation may tell you when to tiptoe (or plunge) back in. Relative valuation can help you determine which stocks to buy.
Right now, reflecting my event risk concern, as well as a possible slowing of the world economy, 40% of my investable funds are in stocks. Assuming no adverse event, my plan is to go to 45% invested with a 10% further decline in the market averages, 50% invested with a 15% decline, and 60% with a 20% decline. A market decline does not change the probability of an adverse event, but it does cushion the fall should one occur, and therefore I am more comfortable with higher stock allocation.
Do I rigidly adhere to this discipline? No. There are always new variables that makes me rethink and reset my buy triggers and investment allocations. But having that discipline helps me avoid panic, and forces me to focus and not lose sight of valuation.
If a major adverse event does occur, stock prices will react quickly and I will then re-assess the impact on the economy and then-current valuations. While such future analysis is beyond even guessing at this time, softening the downside from such an event does seem to me to make sense now. Finally, on the bright side, attractively priced stocks I averaged into after 9-11 and after the 2008 financial crises turned out to be rewarding holdings, even though in some cases I got in too early.
Summary
If you don’t think you are smart (or lucky) enough to catch the bottom (I am not), averaging-in strategies make sense. There is much written on averaging-in strategies, and I cannot add much value here.
But where I do think I differ from the consensus is my belief that the probability of a commerce-affecting and therefore market-affecting adverse event is much higher than generally recognized. My asset allocations will reflect that until the air clears, one way or the other.
This post can also be viewed at SeekingAplha.
For more about investment education, please see our blog at www.whystocksgoupanddown.com
No Comments