Yesterday, readers wrote in with a couple of very good questions about risk.
When does risk turn into reality?
The first reader wrote:
It seems the trend in your message is one of increasing "awareness" of risk. Is this a fair statement to make? And if so, at what point does awareness turn into reality? When is risk enough where economic facts can no longer refute the trending risk?
The idea that I am writing about awareness of risk is spot-on, and the question of when risk turns into reality is really what we're all wrestling with. Most investors are confident when they should be worried, and vice versa, so a big part of what I do here is to keep that awareness high—and to raise it even as things look better. The writer goes on to say:
I get the impression that the economy is strengthening, but that maybe the market and the economy are on different trajectories. My clients ask about debt levels, inflation, etc. I'm trying to distinguish between a hypersensitivity from the last crash, and not falling in love with a market that seems to overcome every obstacle lately.
Again, well stated and a fair representation of what I’m trying to convey. The economy is fairly strong, has been for some time, and is likely to keep improving for a while yet. As confidence rises, awareness of risk tends to fall, and that can be a problem.
Being aware of risk is not enough, of course. I try to tackle the second part—identifying when high risk is changing to immediate risk—by monitoring some key economic and market indicators on a monthly basis. I also highlight what I see as major event risks that aren’t getting enough mindshare—for example, the recent French election and the pending debt ceiling debate here in the U.S. We need to keep an eye on both the underlying trends and the events, and with a daily blog I can do just that.
Right now, though risks remain high (and we have to remain aware of that), immediate risks are still pretty low. The trends are favorable, so most risk at this point will come from events. When trends change, which will show up in my monthly updates, I will spend much more time looking at what that means—and what we should be doing.
The debt ceiling: what are the limits?
The second comment on yesterday’s post offers a good example of what I mean by this:
Appears to me that Congress is "kicking the can down the road" again. Debt limit, no debt limit, new debt limit, raise debt limit, and on and on. Seems to be working (at least for the "protected class"). Are there limits? My guess is that there are.
The observation is an excellent one. There are indeed limits, although no one knows exactly where they are. This is a great example of high risk that is likely not immediate, on a trending basis.
At the same time, there is immediate event risk, posed by both the budget talks and the pending debt ceiling debate. Here, again, there is little systemic risk—we will not hit the fundamental limit on debt anytime soon, based on Japan’s experience—but the probability of event risk is actually quite high. We have to cover both the immediate risk and the trending risk, but they are not the same at all.
Finally, another reader asked how I normally respond to questions. Typically, I answer directly in the comments (for short answers) or by doing a separate post (for longer answers). Is the existing process working well? I welcome your feedback.
I get my best ideas from suggestions and questions, from readers of this blog and from Commonwealth’s advisors and clients. I appreciate your help, and I look forward to more of it in the future. Thanks for reading!