RE-THINKING RISK

A close friend of ours, Charles King, Jr., recently wrote:

The NASDAQ stocks were once again the past quarter’s central attraction. Following its parabolic 70% advance from last October to its high on March 10th, the index then entered a corrective phase that produced a decline of 36% in just ten weeks. That decline was the same percentage as the Dow Industrials fell in the 1987 crash. Much damage was inflicted, and more time will be needed for the healing process to complete itself, but undoubtedly the spring correction has let some air out of the speculative bubble.

Charlie then pointed out that while all these numbers may be of interest to some, the bottom line was the individual’s ability to understand risk.

…the concept of risk is much too vague unless it is tightly linked to some consequence that is meaningful to the one taking the risk.

“Except for the most stubborn holdouts, managers have learned that treating portfolio risk merely as a function of price volatility and variability of the portfolio’s return is incomplete and simply doesn’t go deep enough. Believe me, it’s far more difficult to measure how the pain of loss will affect the owner of the assets than it is to deal with the impersonal math that calculates the volatility involved. Until each investor takes to heart what the pain of actual, and perhaps permanent, loss will entail, the risk of owning the assets has little or no meaning.”

It would be a delightful luxury to buy stocks in great companies and hold them forever. Unfortunately, it doesn’t work that way. The much touted Buy and Hold strategy really boils down to buying the stocks of great companies and hanging on to them as long as one possibly can.

We have gotten a closer look at the nature of risk, but we have not yet tackled the core question of how much risk should be taken in order to achieve a satisfactory outcome. And there is very good reason for this. It’s a very personal and individual thing.

We are pleased that our friend expressed several thoughts about that four-letter word. You won’t hear risk mentioned on CNBC or on the evening news. You won’t see it discussed in the Wall Street Journal or in the advertisements extolling the virtues of their mutual fund sponsors. By the way, remember how many ads there were for mutual funds last year? We don’t have the data, but the number of those ads we have seen in the past several months is a fraction of what they used to be.

It is very positive that the mania is cooling off a bit. There are now reports that 75% of the “dot com” companies won’t be around a year from now. Of course that is only someone’s guess but it does mean that the marketplace’s winnowing-out process is at work. The result will be that the remaining “dot com” companies will be serving the consumer and making a profit as a result.

Several very important questions for the stock and bond markets that are as relevant this month as they were last month are:

– Will the Fed stop increasing interest rates?

– Is the rate of inflation increasing at a rate that will bring about pressures for significant wage increases?

– Will oil continue to stay at record levels over $30/barrel?

– What will the breakup of Microsoft mean if it is split into two separate companies after further court appeals?

· Has the Nasdaq, which peaked at 5132.52 on March 10th and closed on May 31st at 3400.36 — down 1,732 points or 34% in a little over 2 ½ months, shrunk enough to begin to stabilize? [As of this writing the Nasdaq has been rallying.]

Especially relevant, in our opinion, is the last question that essentially addresses the issue of the level of many high flying stock prices that have come down on the order of 40% to 85%. As referred to above — the words “dot com” behind a company’s name have lost a great deal of their glitter recently.

For the first half of 2000 and the 12-months ending June 30, 2000:

– The Dow Jones Industrials fell 9.13%. The 12-month change was minus 6.21%.

– The S&P 500 fell 1%. The 12-month change was plus 4.56%.

– The Nasdaq Composite fell 2.54%. The 12-month change was plus 44.69%.

Positives are that 1) inflation as of this writing continues to be minimal. 2) With the violent shakeout of many of the high-flyers, the mania and speculation in the stock markets seem to have abated a bit. 3) Second quarter earnings have reflected many gains in productivity and profitability that enable us to feel more comfortable with buying and holding strong companies despite their price fluctuation. 4) In our opinion, there are now more investment opportunities having a more favorable risk/reward ratio than there have been for quite some time.

John W. Hamilton
July, 2000