The Greatest Risk Is Often Not Taking Sufficient Risk

Published:

Authors:
David Sowerby, CFA, Managing Director, Portfolio Manager


Consider the list of global and domestic risks that investors are facing today: conflict in the Middle East and Ukraine, tensions in the South China Sea, inflation, border issues, the upcoming Presidential election, federal spending and debt and, of course, additional risks that we are not yet aware of.

This list feels longer than usual, so it is understandable why an investor might seek the perceived safety of their mattress, otherwise known as cash, for their portfolio allocation. However, we know that diversified portfolios with an appropriate allocation between stocks, bonds and alternatives have traditionally provided the optimal balance of participating well in up-markets and, importantly, protecting capital in down-markets. This is an effective way to think about an allocation; a balance between return-seeking assets and risk-mitigating assets.

Allocating to return-seeking assets is based on the long-held belief that, in aggregate, U.S. companies create shareholder value, even in the face of mounting global and domestic uncertainty. Just consider the following:

  1. As of the first quarter of this year, corporate profit and cash flow margins were at some of their highest levels in the last 20 years. Notably, my preferred metric of free cash flow margin, meaning the cash left over in American businesses for shareholder distributions, buybacks and reinvestment, is higher than pre-pandemic levels despite our long list of current risks.
  2. We are now more than four years out from the stock market’s February 2020 peak, just prior to the pandemic, and the U.S. stock market is up more than 60% since then. That accomplishment is even more impressive considering we have witnessed two bear markets in that timeframe (in 2020 and 2022). U.S. stocks, despite all sorts of headlines, have meaningfully outperformed Treasury bills, which returned a cumulative 9% over that same period.

The belief that there is risk in not taking sufficient risk is best exemplified by the description of being an optimistic realist when investing. The following chart shows the long-term path of U.S. GDP (Gross Domestic Product) per capita, overlayed with the S&P 500 Index, used as a representation of the U.S. stock market. One can see that economic and profit growth are well correlated to the gains in the S&P 500, which delivered an 11% compound annualized return since 1950.

U.S. GDP Growth vs. S&P 500 Growth

U.S. GDP Growth vs. S&P 500 Growth
Source: FRED

The U.S. stock market has consistently demonstrated that, over a reasonable five-year interval, companies are skilled at delivering shareholder value. While the long-term 11% annualized return for U.S. stocks is less likely in the next five years, an annualized total return (price appreciation plus dividends) of 7-8% is realistic given the likely path of profit, cash flow and dividend growth for U.S. companies. And as stated at the outset, there is a risk in not participating in that type of growth potential within your portfolio.

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