1st Quarter Client Note

By Steven Smith | Newsletters

Apr 09

Despite extraordinary seismic (Japan) and geopolitical (Tunisia, Egypt, Libya) events during the first quarter, the equity markets experienced a strong gain. The S & P 500 Index returned 5.92%. The Dow Jones Industrial Average, up 6.41%, had its best first quarter since 1998. Mid and small-cap stocks continued to outpace large company stocks and for the first time in a while value beat growth.

Clearly the events in Japan are taking a tragic personal and economic toll on that country. Our hearts go out to the people of Japan over the loss of life and property. It is estimated that recovering from the earthquake/tsunami and nuclear melt-down will cost that country $300 billion. This will be a drag on the world economy, as well; although Japan’s share of the global economy has diminished to 9% from 18% in the past 15 years.

Otherwise, the global economy appears to be continuing its slow recovery from the recession of 2007/2008. Unemployment in this country remains high. And the real estate market continues to be plagued by underwater mortgages and foreclosures. Bank capital requirements and European sovereign debt issues are going to take considerable time and some pain to resolve.  It is clearly going to take a long time to recover completely. And we still may slip into another recession.

The Dread to Risk Ratio

Following the Tsunami, Princeton University physicist Robert Socolow published a piece on the Fukushima disaster, introducing the concept of the “dread to risk ratio” faced by humanity in dealing with both the aftermath of the accident and with nuclear power in general. The ratio refers to the gap between the actual risks of an activity as calculated by experts and the risk as perceived by us mere mortals. Often the described risks are steeped in scientific jargon and the conclusions are ambiguous. So it is no wonder that we have a difficult time making policy and managing our emotions around such issues.

It struck me that the dread to risk ratio also applies in investing. Nuclear power will never be perfectly safe. Nor will investing. Unpredictable, exogenous macro events are a significant component of the overall systematic risk that is reflected in market prices. And those prices change dramatically each time we experience such an event. Managing that risk demands getting your own, personal dread to risk ratio as close to one as possible. The best investors manage risk with proper asset allocation, broad diversification (with no outsized bets on any one country or company) and disciplined rebalancing. And remaining philosophical.

Wishing you a Happy Spring,

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