Since the 1980’s, the American financial and monetary establishment has gotten better and better at bundling risk. This bundling can be a boon, but sometimes leads to catastrophe. Most famously, bundled mortgage securities blew up the banking industry in 2008.
Lending anyone money is risky. This is true whether you’re getting a promise of interest or a share of profit. If you buy a company’s stock, you expect some sort of dividend (or price rise). If you buy a bond, you won’t partake in increased profits, but you will get a guaranteed level of income (buyer beware, this is guaranteed NOMINAL income that could potentially be destroyed by inflation). But just buying one stock or one bond doesn’t seem smart. Any time you expand past one security into many, you’re bundling your risk to be safe. A bank that lends to 10 million people should thus be safer than a bank that lends to 100 people.
Spreading that risk should ensure safer returns. We’ve heard over and over that market returns beat bonds and cash during every 20-year time period, yet stock prices are volatile, so we have risk. But the more we diversify, the less risk there should be. Therefore, instead of holding a portfolio of 10 or 20 stocks, you should buy the Vanguard Total World Stock ETF (VT), which holds almost 7,000 stocks. When you’re facing 2% 10-year treasury yields, what else can you do? Buy a complete diversification of equities that will grow over time without the volatility. Amazing, right?
Not quite. By diversifying, we’re balancing risks. With ultra-diversification, risk seems to disappear. But when risk apparently vanishes, it actually comes back to life as systemic risk. Mortgage-backed securities supposedly made poor-credit loans less risky by packaging them across geographies. That “banishment” of risk led to systemic risk and collapse.
A similar principle happens with monetary policy. The longer we go with 2% inflation and no major economic catastrophe, the more we trust the Federal Reserve to keep economic aggregates growing at a sufficient rate. The Fed slipped on those expectations in 2008, but recovered with successive rounds of QE afterwards to keep our inflation expectations stable. That stability prompted us to take on more risk because we have a Fed put. Things won’t get too terrible because the Fed won’t accept that (and rightly so, I might add).
With mortgage-backed securities, ETF’s and Federal Reserve targeting aggregate demand, we banish risk from our credit decisions, from our house prices, from our stock portfolio, from our very economic lives.
Though I pick my own stocks (as an analyst and value investor, I accept more risk for myself because I’m confident in my abilities – see my article “Man up and pick your stocks“), I would recommend to others with basic investment questions to just average into an S&P index fund (or the VT I mentioned earlier). As an aside, I am long WMT, CBI, KO, WFC, BACHY, GSK, COH, TM, HSBC and own call options on PBR and DB.
But I do wonder at the facade of safety that ETF’s provide us. I think it a tremendous advance that any individual investor can diversify to such an extent without the fees of a managed portfolio. And I’m a big believer in the long-term returns from the stock market as opposed to cash or bonds (buy and hold seems like a no brainer). But do recent, all-time highs reached by markets mean that systemic risk is building, and is it building because we have investment vehicles that spread risk more than before? To put it simply: by diversifying so much, are we putting up with more and more crap in our portfolios that just doesn’t belong there?
I remain bullish on equity markets (especially if you can find value areas in Buffett stocks, or in liquid markets outside the US), but as an open question to readers: Are ETF’s contributing to systemic stock market risk, or are they allowing us low-cost diversification and rightfully pushing up valuations?