It is no surprise that few people worry about financial risk when the stock markets are rising. From the start of 2019 until last Thursday, February 19th, North American stock markets had a terrific run. During that period the broad S&P 500 index rose 35.4% and the technology focused NASDAQ rose a gaudy 48.3%. Many investors were too busy looking at their gains to worry about what might come next. However, risk is always present, and it made itself felt in the last five trading days.
With the headline-grabbing Dow Jones Industrial Average down an eye-popping 2,611 points or 8.8% in ten days, it is useful to think about four distinctly different risks that investors face when buying stocks. Three of them came into focus for us this week, but luckily, not the fourth.
The worst and most dangerous risk is Systemic Risk. This is what we confronted in October, 2008, when it appeared that the entire world financial system might fail and fall into disorder. Systemic risk is rare in developed economies but it can be seen today at work in Venezuela where inflation is so high it cannot be measured. At this time no serious economist thinks the world or any country, even China, is facing a systemic risk. Central banks and governments are prepared for most eventualities and have tools at their disposal. The government of Hong Kong this week literally threw money at the problem, writing cheques of HK$10,000 to each citizen to increase the demand for goods and services. We are not worried about systemic risk affecting any developed country.
The second kind of risk is called, confusingly, Systematic Risk. This is the risk that an entire group of related assets, such as stocks or real estate or bonds, will all fall in value at the same time, and not necessarily for any easily understood reason. The fall in global stock markets in the past week is a perfect example of systematic risk. To a great extent it did not matter what stocks an investor owned; pretty much everything sold off in reaction to fears over the spread of coronavirus. Systematic risk is why we diversify our assets, holding fixed income for all but aggressive accounts. Experience shows that when systematic risk strikes, it can reverse just as suddenly, and an upward move can be just as abrupt as the downward one.
In an event like the current health crisis, clearly some sectors of the economy are more exposed to adverse consequence than others. For example, travel will obviously be hard hit, and this is an example of Industry or Sector Risk. All portfolios need to be immunized from sector risk by diversifying among a number of industries and ensuring that the amount of capital allocated to any one sector is not too great a proportion of the portfolio. Often, different sectors move in opposite directions, meaning that diversified portfolios will have lower volatility than highly concentrated ones.
Finally, the fourth risk is Company Specific Risk. Some companies are like the victims of a drive-by shooting, just in the wrong place at the wrong time. Clearly shares in these firms will be more affected than others that are merely sold off along with the rest of the market due to systematic risk.
On Tuesday afternoon the Portfolio Management Committee of Baskin Wealth Management met to review our client’s exposure to sector and company specific risk. We are well aware that there is nothing we can do about systematic risk, and that attempting to time the market to avoid it is a futile and usually expensive and self-defeating endeavour. However, the same cannot be said of the risks that are specific to any particular stock. For this reason the committee discussed in detail each of the fifty companies that currently are held in our client portfolios. We posited the question: What might happen to each of these companies in the event of a global coronavirus pandemic? We, of course, do not know how severe this disease will turn out to be, but risk management is about looking at worst cases, so that is what we did. Here is what we found.
Only four of the fifty companies were judged to be at particularly high risk. We took the decision to sell two of them, Delta Airlines, and Hyatt Hotels. It may be that global travel will recover quickly and that airplane seats and hotel rooms that are now empty might fill up again sooner than we expect. However, we felt the risk of selling now was lower than the risk of waiting to find out. Two other companies that we think might have problems are being held for now, but we are paying very close attention to them.
Of the other forty-six companies, 12 were judged to have some exposure to a severe disease outbreak, and a further 34 were judged to have very little exposure. As a result the committee decided that no action was required in regard to the great majority of our holdings.
We are acutely aware that our clients have entrusted us with their funds in the expectation that we will make prudent decisions and take such action as may be necessary to avoid undue risk. We believe we are doing that, and of course, we will continue to do so in future days.
Systematic risk is a fact of life in the stock markets. Since the great recession that ended in March, 2009, there have now been 26 separate times that the broad market indexes have fallen at least 5%. That’s an average of about twice a year. The recent fall is therefore not anything unusual or unexpected. The underlying reasons for this particular sell-off may be open to question, but clearly the situation with the global spread of coronavirus is somewhat novel and does require special attention.
As the situation evolves, we will continue to evaluate the situation. In the meantime, we are as always happy to speak to you and discuss your own questions and concerns.
