There is more risk in the world than most people realize, and it is often inadequately measured. Frequently practitioners measure risk using “standard deviation,” which assumes returns are “normal.” But what does this really mean?

 In a “normal” world, few surprises exist. Yes, there would be good and bad days in the market, but the ups and downs would be largely predictable, and good returns would mostly offset bad ones. If someone tells you they measure risk using “standard deviation,” they imply the world is dull and uneventful.  

Enter Common Sense

Even the most casual observations about the past couple of decades cast doubt on this “dull world” vision. Not only has the market experienced outsized bull runs, but also jaw-dropping declines. Systemic shocks to the financial system are far more common than expected by the “dull world” theory adherents. Panics seem to surface with increasing regularity and can roil markets unexpectedly. All of these events create what we call “tail risk” —  a rare occurrence that comes as a surprise and can turn a portfolio on its head.

Recent examples of adverse “tail risk” include Covid-19 (2020), Federal Reserve triggered taper tantrum (2013), European debt crisis (2011), Global Financial Crisis (2007-2009), several emerging market crises, the dot-com bust (2000), and U.S. corporate accounting scandals (2001-2002).

So, as you can see, the world is anything but boring. This common sense realization should put to rest that market returns are “normal” and that risk can be adequately measured by “standard deviation” alone.

How Can We Look at Risk?

The chart below offers a different and better way of looking at risk. It is called a “normal probability plot.” Despite the intimidating sounding name, it is simple to understand if you understand two points.

  • Point 1: A steeper line drawn through the points on the chart indicates more volatility.
  • Point 2: The more the dots depart from the straight line, the greater the degree of “tail risk” or probability of an unexpected outcome.

By looking at risk through this lens, we go beyond the inadequate “standard deviation” measure of risk and incorporate the fact that market returns are not “normal.”

Testing for “Normality” of Returns
Normal Probability Plot for “A” vs. “F”-Quality Firms

What Can We Do About Risk?

As shown in the chart above, owning high-quality companies can lessen risk. It can diminish both the day-to-day volatility (flatter line) and reduce the probability and magnitude of an unexpected outcome (“tail risk”). This should sound reasonable because high quality implies more flexibility, durability, and predictability, fundamentally mitigating risk.

We define quality grades based on operating consistency, asset profitability, and financial leverage. “A”-quality companies tend to have consistent operating profits, more productive assets, and lower debt. “F”-quality companies tend to have erratic profits, less productive assets, and more debt.

Not surprisingly, “A”-quality companies exhibit less volatility and lower tail risk.

Conclusion

As time goes on, evidence is mounting that risk is changing. Significant declines have become more common and episodic. Debt has become more prevalent in the financial system. The system itself has become more complex.

For these reasons, we think now is the time to take a closer look at risks that can disrupt your portfolio. Washington Crossing looks to mitigate these risks using fundamental analysis and active management focused on quality at a reasonable price.

Disclosures:

The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.