Risk-On/Risk-Off

Drama. Mr. Cramer has railed against the use of these terms – Risk-On/Risk-Off – as being “a ridiculous bit of hedge-fund-ese for the intellectually lazy” and, undoubtedly, it is, because “none of these blowhards will let you see their returns after what I bet was a fiasco year (2012) for what I can only call an “alleged” strategy” (TheStreet, January 2, 2013, Let This Be the Death of ‘Risk-On/Risk-Off’). Indeed. Anyone who uses those terms, and, even worse, acts on them, and, still worse, causes us to act on them, deserves the Donkey’s Grin and we ought to give it to them because it’s our money that they’re risking, on and off (absent a mirror).

Exhibit 1: Risk-On/Risk-Off As Commonly Used on Wall Street

2009 Risk-On / 2008 Risk-Off

“Risk-On” means that the price is “low” and therefore more likely to go up than down; buy the value and take a chance; and
“Risk-Off” means that the price is “high” and therefore more likely to go down than up; take profits and fend off a lower price.

More grandly, we have Risk-On if the investor “risk appetite” is “elevated” and Risk-Off, if not; for example, 2009 is perceived as a Risk-On year, despite the experience of just several months before in 2008 which was perceived to be a Risk-Off year.

We must  try not to chuckle as the banks and insurance companies tell us about their changes in the “risk appetite” and it’s a pity that a good concept and handy description have been rendered useless and, provably, dangerous. The year 2012 can be said to have been a year of Risk-Off and tepid returns; and the beginning of 2013, a year of  Risk-On and, hopefully, excess returns; but what do we know about the rest of the year or even next week? Nothing.

In our view, the reason that these terms come up is that the current generation of investors and economists, and their fathers, equate “risk” with the possibility of a loss or gain (and “instant” in the case of volatility-based investing) in the “price” of a “thing” whether it be goods or services, stocks or bonds, houses, cars, paintings, t-shirts and running shoes, et cetera; in contradistinction to the thinking of their grandfathers, that “risk” is the possibility that we might not get our money back and a hopeful return above the rate of inflation. Or in other words, “risk” is the possibility that we might not get a non-negative real return; which is to say that “risk” is the possibility that we might get a negative real return on our money.

That distinction can be made about just about anything that we might buy or “invest” in, such as goods, services, education, marriages, stocks and bonds, and so forth, because that’s what an investment is; it is the purchase of “risk” and the uncertainty of a non-negative real rate of return, whether “return” is measured in “money” or some other numeraire such as “green” or “good” – and that can be tested with real data (please see our Post, Proactive Risk Management For Everybody & The One Rule, May 2013, and Earnings Don’t Matter, April 2013, for how to test these things).

If we think about it that way, then we buy stocks that are (N) with “Risk-On” and stocks that are (B) with “Risk-Off”; and the words actually mean what they say. Portfolios of stocks that are (B) and, therefore, Risk-Off, have the property that they will tend not to lose in value – that’s a given – but they also have the “surprise” property that they will tend to produce “excess returns”; that is, returns above the rate of inflation.

On the other hand, portfolios of stocks that are (N), and, therefore, Risk-On, have the property that they will tend not to gain in value (although not necessarily demonstrate an actual excess loss of value which is a surprising asymmetry between Risk-On and Risk-Off that can be explained by the theory; please see the references below). Nevertheless, 2013 is Risk-On, and we might take some caution in that fact because it means what it says – we are using our money to buy stocks – and we note that the run-up in 2007 was Risk-On leading into 2008 which was Risk-Off and we used (or sold) our stocks to buy money. But, we can also say that if we are carrying a portfolio (B) of stocks, then it must be “as good as cash” and, hopefully, “better than money”; and it is.

For example, if we make that distinction in the stocks of the NASDAQ 100, then the portfolio (B) which we usually call the Perpetual Bond™ in its most basic form (without the selling discipline and “price protection”; please see almost any of the (B)(N)-Company posts) has the behavior shown in Exhibit 2 below; and the portfolio (N) which we usually call the Contra Portfolio™ has the behavior shown in Exhibit 3 below (for more information on the chart elements, please see our Post, NASDAQ 100 – (B)(N) There And Done That, June 2012):

Exhibit 2: The Perpetual Bond™ (B) – Portfolio Value and Cash Flow – 2009 through 2012

Exhibit 3: The Contra Portfolio™ (N) – Portfolio Value and Cash Account – 2009 through 2012

The Price of Risk

The calculated Risk Price (SF) is a provably effective estimate of the “price of risk” which is “the least stock price at which the company is likeable” (Goetze 2009) and “likeability” is determined by the demonstrated factors of “risk aversion” – we want to keep our money and obtain a hopeful return above the rate of inflation – and the properties of portfolios of such stocks.

Stock prices that are less than the price of risk can be said to be “bargain prices” but with the risk attached that the company might never get a higher price other than that due to ambient volatility or “surprise”; on the other hand, investors who are willing to pay the “full price” above the price of risk, and buy and hold the stock at those prices, must also be confident, and have reason to believe, that the company will produce those values, absent new information.

Please see our Posts, The Price of Risk, August 2012 and The Nash Equilibrium & Its Stock Price, October 2012, for more information on the theory.

To see what else “risk averse” investing can do for us, please see our recent Posts, The Wall Street Put, April 2013, and earlier Posts such as The Dow Transports, March 2013, or The Risk Adjusted Dow, March 2013, or The Canada Pension Bond, February 2013, and for a more colorful description of investment risk and the application of the “price of risk” to mergers & acquisitions, please see our Post, Bystanders & Collateral Damage, April 2013.

Postscript

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond™
“Alpha-smart with 100% Capital Safety and 100% Liquidity”
Guaranteed
With No Fees and No Loads on Capital

For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used. Related data may be obtained from us for free in a machine readable format by request to RiskWerk@gmail.com.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.