Energy cannot be created or destroyed; only altered in form. If you recall your high school physics lessons, you may recognize the First Law of Thermodynamics. Also known as the Law of Conservation of Energy. Solar panels do not destroy solar energy or create electricity; they simply transform one into the other. This law is universally true of interactions between subatomic particles occurring all around us. Energy is neither created nor destroyed but constantly transmogrified.
I am no physicist and am reluctant to speak further on thermodynamics. Though I find the Law of Conservation of Energy resembles a concept I’ve been formulating which we’ll call The Law of Conservation of Risk. That is, the risk in an investment portfolio can neither be created nor destroyed; only altered in form.
The Law of Conservation of Risk is less an academic discovery than an observation of our own with a (hopefully) piquant sobriquet after years managing portfolios and studying the markets. A finance PhD sitting in an ivory tower at the University of Chicago may object to my use of the word “law.” But it is at least directionally correct, and we are not the first to make the observation. Corey Hoffstein of Newfound Research, among others, has observed the phenomena.[i]
Every investment portfolio consists of numerous binary decisions: to own a position (as well as how much) or to avoid owning a position. A simple example is a portfolio invested completely in Apple stock. You made three decisions:
- You will buy Apple stock
- Apple stock ownership will comprise 100% of your portfolio
- You will not buy Microsoft stock or an international index fund or a treasury bond or an equity REIT or Bitcoin or shares of a private equity fund, or a currency arbitrage strategy, or long-dated call options on an obscure biotech stock or anything else.
This portfolio has plenty of risk. Importantly, you have significant exposure to some risk and little exposure to others. The biggest risk present in the Apple portfolio is what academicians call unsystematic risk. That is, the risks specific to an individual company. “Concentration risk,” colloquially. The stock market could do well while Apple performs poorly. What if China decides its citizens can no longer use iPhones? (China makes up 20% of Apple’s sales and Chinese authorities banned the use of iPhones by government officials in Q4 ’23)[ii] Or what if the next few generations of the iPhone disappoint? Or Tim Cook dies and his successor isn’t up to the task? Or Elon Musk creates a computer chip that everyone plugs into their head making smartphones obsolete?* I don’t know! Concentration risk is everywhere when you buy individual stocks. But the “Apple Portfolio” is pretty safe from interest rate risk, which affects holders of a company’s (or government’s) debt more so than equity holders. Apple is sitting on a cash stockpile of $162,100,000,000[iii] presumably earning ~5% interest and can issue debt at near treasury-level interest rates. The Fed can keep raising rates all it wants, I don’t think Apple really cares. It is also probably pretty well insulated from inflation risk. Apple has pricing power. If input prices increase, they can pass those along to the end consumer to preserve their margins (and stock price).
Let’s take concentration risk off the table. Instead of buying Apple stock, you buy an ETF tracking the S&P 500 index. Suppose Emperor Xi does kick Apple out of China. Brutal for Apple stock, but Apple is only one of the 500 companies you now own. And perhaps Apple’s loss will be another one of your portfolio positions’ gain. The concentration risk is gone, but you’ve introduced systematic risk, more commonly known as market risk. That is, the risks inherent in the entire market. Imagine a company that blew out expectations in their quarterly earnings call in February of 2020. It probably didn’t matter! Governments shut down economies in March of 2020. Just about all stocks were crushed in February and March of 2020. February earnings blowouts were overwhelmed by market risk (pandemic). The Law of Conservation of Risk. You removed one risk from your portfolio but added another.
Say it’s 2020 and you can’t imagine exposing yourself to the risk of stocks in the midst of the COVID-induced madness. You invest your portfolio in U.S. treasurys. Finance textbooks call treasurys “risk-free.” You loan money to the U.S. government, it’s a good bet they’ll pay you back. You’re trying to decide between one-year treasurys and 30-year treasurys. The 1s pay you back after only one year with a paltry 0.16% interest rate. The 30s are paying 1.27% (8x more than the 1s).[iv] You buy the 30-year treasurys (8x!). No exposure to the vagaries of the equity markets. You breathe a sigh of relief. Then this happens:
No market risk. No concentration risk. Boatloads of interest rate risk. Buying 30-year treasury bonds in 2020 felt like you were removing risk from your portfolio. And they paid much better than the 1s (8x!). But you can’t cheat the Law of Conservation of Risk. The Fed started hiking interest rates in 2022, and by the end of 2023, one-year treasurys were yielding 4.79%.[v] No one wants your 30-year bonds with 27 years left to maturity paying 1.27% when they can buy 1s yielding 4.79%. So the price of your 30s plummets and interest rate risk incinerates your “risk-free” portfolio. You didn’t reduce the risk of your portfolio so much as alter its form. Even a “risk-free” portfolio can’t escape the Law of Conservation of Risk.
You would have been better off buying 1s back in 2020. One-year treasurys mature in a year, so they are much less sensitive to interest rate risk. You buy 1s, rates go up, that’s fine because your bond matures in a year and you can reinvest it in a new bond bearing a higher interest rate. Here’s what a short-term treasury portfolio looked like over the same time span as the wealth incinerator shown above:
Not a great annualized return but better than a 39% loss.
You avoided interest rate risk and concentration risk and market risk, but you did not avoid the Law of Conservation of Risk. For a few years, your yield was far behind inflation. If you earn 2% annually and inflation runs at 7% annually your purchasing power erodes by 5% annually. The whole point of an investment portfolio is accreting purchasing power:[vi]
But there is another risk lurking in your portfolio of short term treasurys far worse than inflation risk. Eschewing market risk is nice when the market is down, but destructive when the market is up. We’ll call the risk of being out of the market during a runup (which happens three out of every four years, by the way) opportunity cost risk. From 2020 - 2023, a portfolio of treasurys was crushed by opportunity cost risk:[vii]
The Law of Conservation of Risk. You cannot remove risk from your portfolio, you can only change its form.
Many financial advisors tie themselves in knots trying to determine a client’s risk tolerance. They send 10 question multiple choice questionnaires to gauge risk tolerance. Would you be willing to gain 30% in your portfolio if it meant you may lose 30%? We find these questionnaires worse than useless. They seek to gauge your tolerance for some risks while ignoring others. As shown above, you can remove market risk from your portfolio and still get hosed. But if your 10-question multiple choice quiz says you should have a portfolio 90% invested in bonds and you get crushed by inflation risk and opportunity cost risk, don’t look at your advisor! His backside is covered by the questionnaire. Worse than useless.
We think portfolios ought to be designed paying respect to the Law of Conservation of Risk using the following framework:
- What risks can you afford exposure to?
- What risks can you not afford exposure to?
- Construct a portfolio long the risks you can afford exposure to and short the risks you cannot afford exposure to.
Suppose you have two portfolios: a short-term portfolio you plan to withdraw from for a down payment on a home in two years and a long-term portfolio you plan to withdraw from in 30+ years to finance your retirement. The Law of Conservation of Risk states you cannot avoid risk in either portfolio, but you can choose which risks each portfolio is exposed to.
You cannot afford exposure to concentration or market risk in your short-term portfolio. There is little certainty any individual stock or the equity markets in the aggregate will be worth more two years from now than they are today. The stock market is positive three out of every four years historically. Pretty good odds, but not good enough to bet your down payment savings. You can tolerate exposure to inflation risk and opportunity cost risk. High inflation over two years isn’t ideal but it won’t keep you from buying a house. Inflation risk is brutal when measured over decades, not years. Staying out of the equity markets for two years during a nice rally isn’t a difference maker either. So you construct your short-term portfolio long inflation and opportunity cost risk and short concentration and market risk (i.e., money market funds, short-term bonds, 1-2 year treasurys, etc.). This portfolio still has risk! Because it must. But they are the risks you can afford.
What about your long-term retirement portfolio? The one you won’t touch for 30 years. You cannot afford inflation risk. At the long-term average of 3% annual inflation, prices increase roughly 2.5x over thirty years. You need portfolio growth exceeding 3% annually to simply avoid erosion of purchasing power. We don’t believe you can afford any concentration risk. Individual stocks can (and have) gone to zero. But you can afford plenty of market risk. The worst 30-year run in the stock market’s history was 1926 – 1955. The market’s annualized return for that period was 7.8% for a total return exceeding 850%.[viii] One more time, in case you glossed over that:
The worst 30-year run in the stock market’s history was 1926 – 1955 during which it returned 7.8% annually for a total return exceeding 850%.
You ought to be happily long market risk in a 30+ year portfolio while short concentration, inflation, and opportunity cost risk. Of course, being long market risk means enduring some nasty stretches. During the last 50 years, the S&P 500 lost half its value on three separate occasions and over 25% of its value on four more occasions.[ix]Despite three halvings and another four quarterings, here’s the S&P 500 over the last 50 years:
You probably can’t even spot all three halvings. Just blips on the screen.
One other note: you will inevitably hear some advisors (*ahem, salespeople*) talking about some product that protects from downside risk. You hear that pitch with insurance products and covered call strategies and private equity ventures and hedge funds to name a few. Remember the Law of Conservation of Risk. Any product or strategy or fund offering protection from downside risk is simply swapping one risk for another (usually for a hefty fee/commission!). Remember the framework:
- Risk cannot be created or destroyed, only altered in form.
- Identify the risks you can afford exposure to.
- Identify the risks you cannot afford exposure to.
- Construct a portfolio long the risks you can afford exposure to and short the risks you cannot afford exposure to.
Sean Cawley, CFP®
*I would love to find a way to unglue humanity from smartphones. But please not via brain chips!
[iv] YCharts, Fundamental Chart, 1 Year Treasury Rate/30 Year Treasury Rate, 01/01/2020 – 12/31/2020.
[v] YCharts, Fundamental Chart, 1 Year Treasury Rate, 12/31/2023.
[vi] YCharts, Fundamental Chart, 1 Year Treasury Rate, US Inflation Rate, 04/01/2020 – 12/31/2022.
[vii] YCharts, Fundamental Chart, ^SPX/SHV, 01/01/2020 – 12/31/2023.
[ix] Yardeni Research, Inc. “Stock Market Historical Tables: Bull & Bear Markets.” October 28, 2022.