Jeff Miller | Jul 10, 2015 12:26AM ET
The single most important question for investors is right-sizing risk. In Part One of this series I emphasized that risk was an individual matter. You cannot depend upon wise investors, no matter how good they are, to tell you what your asset allocation should be. It is fine for Warren Buffett to go “all in” on stocks versus bonds, but he can afford to be wrong!
With that background in mind, let us turn to evaluating downside risks. With China at the forefront of attention (for a moment at least until the pundits turn back to Greece or the Fed or deflation) we’ll take that as the focus.
Headline Risk
The most common discussion of risk – by far – is “headline risk.” This is the result of the media reward system that attracts attention to anything that is going wrong and draws facile cause and effect relationships. No matter how hard you try to be rational, the media pounding is too powerful. Experiments in behavioral psychology invite listeners to pick a random number. Later answers are anchored to the number. Who cares whether the plane landed safely? It is powerful psychology, but you get paid if you can take a deeper look.
In my “young prof” days I took the bus home from the university and got off a block from my apartment – a nice neighborhood. It was twilight. I was dressed in a coat and tie. As I walked toward my place I noticed that the woman walking thirty yards in front of me was accelerating and looking back over her shoulder. Naturally I slowed my pace, but I have always remembered her reaction – a teed up suspicion from too many TV shows.
And so it is with today’s investors. So many sources get paid to frighten you, making sure that you are scared witless (TM OldProf Euphemism).
Today’s headline is China. The story line goes something like this:
The story is seductive and easy to write. And so many have!
Analyzing the Downside Risk — and the Opportunity
Taking the perspective of an investor with a free choice of asset allocation, the biggest challenge is to get beyond the headlines and insist upon data.
The first two points in the mainstream narrative above are clear enough, reflected in traditional metrics like P/E ratios. Trading the Chinese market could be profitable for traders, but you needed to be agile. Felix played here, but it was not attractive for long-term investors.
When analyzing risk, we need to get beyond the headlines and focus on data. It often helps to consider the various possible investments.
Direct investment in China
This has been very dangerous. Now it is becoming more attractive. Goldman Sachs’ Timothy Moe opined that a bottom was getting closer. I liked his breakdown of stocks into offshore China (cheap at 9.6x forward earnings and also good on book value, yield) Hong Kong (OK on all metrics) Shanghai (still a bit expensive) and small caps (the highest valuation). We are considering the mainstream stocks for our “high octane” accounts and we already own BABA.
Contagion Concerns
An important question is whether a popping of the bubble has any implications for the Chinese economy. Because of the general lack of economic data and suspicion about the reports, the Chinese economy is a fertile ground for pundits of all stripes. Sorting out reality is challenging. My own assessment is as follows:
Investment Implications
Conclusion
Analyzing risk is tricky, especially when headlines and pundits oversimplify the story. A successful investor knows how to take a deeper look. In particular….
Beware of “headline risk” — already known and reflected in market prices.
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