Ken Solow   |   January 9, 2012

Buy and Hold investors tend to view risk as ‘tame’ rather than wild, and often believe it can’t be managed. In this view, risk (defined as volatility) can be measured by a standard bell curve or normal probability distribution, where unexpected events are highly unlikely. Also, market movements are assumed to be completely random, so risk can’t be managed. The best you can do is to diversify your portfolio and wait patiently for historical long-term average returns to materialize (hopefully, before you die).

As active managers, we believe that unexpected market events happen frequently, and that the tails of a normal probability curve don’t accurately account for their likelihood. We also think risk can be managed: Viewed through the lens of the market cycle, wise investors should take less risk when the economy is going to contract, when other investors are overly enthusiastic, and when risk assets are expensive or overvalued. On the other hand, informed investors should take more risk when the economy is expanding, when other investors are overly depressed, and when risk assets are cheap. We believe that short-term market movements (measured in days) are impossible to forecast, but that over the market cycle, we can assign probabilities for both the news and investor response to it; that helps us determine how best to manage risk in our client accounts.

Last Friday’s positive employment news is yet another data point leading to a conclusion that the U.S. economy is beginning to find some traction, and we would normally respond enthusiastically by adding risk assets in our clients’ accounts. But it’s also clear to us that “tail risk” or systematic risk (risk to the entire financial system) is very high at the moment. The evidence is overwhelming that we’re in the middle of a credit event in Europe that has the potential to crash the banking system. This is the tail risk we must deal with in the post-Lehman investment environment. We can measure this in a variety of ways, including nominal interest rates, interest rate and swap spreads, and credit default swap prices — all of which tell us that investors are very nervous about the banking system. Even if policy makers manage to keep the system from blowing up, market cycle risk in Europe is also very high. In other words, even if we ignore tail risks, the chance of a deep recession in Europe creates problems for risk takers who believe that there’s money to be made by buying in front of an unexpected solution to the European sovereign debt and banking crisis.

So what to do? Last year Pinnacle booked a good year in terms of beating our competitive universe of asset allocation managers, including really big guns like Blackrock and Pimco. Notably, the average hedge fund lost 5% last year. On the other hand, we trailed our investment benchmark by about 2% (Please read our disclaimer regarding statements on investment returns.) Unfortunately, the benchmark doesn’t ‘know’ anything about tail risks. If risk assets drift higher due a short-term (or even a long-term) improvement in the U.S. economy, the question remains whether we should buy them in light of the systematic risks we see around us. I wouldn’t be surprised if we continue to edge risk assets back into the mix as we give recent economic data the respect it deserves. However, ever since the market bottom in March of 2009, we’ve found it difficult to get unequivocally bullish due to the level of systematic risk in this environment. I don’t see that problem going away any time soon.