Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.
Jason Stipp: I'm Jason Stipp for Morningstar.
After the financial crisis of 2008, a lot of investors would say they have a good feel for risk, but Pat Dorsey, President of Sanibel Captiva Investment Advisers, says many investors would do well to reframe their notion of risk.
He's here to explain why. Thanks for joining me, Pat.
Pat Dorsey: Always happy to be here.
Stipp: You wrote recently a little bit about risk, and you mentioned that a lot of different people have a lot of different perceptions of risk. Can you walk through what different things risk means to different types of investors?
Dorsey: This is a little bit like discussing the existence of God with a theologian. An academic says risk is volatility--the more an asset bounces around in price, the riskier it is.
A mutual fund manager might say it's career risk. If he lags his benchmark for too long, he gets fired.
An individual might frame it as pain. Of course, we feel losses much more than we value gains. So just seeing your portfolio go down is a lot of risk.
And of course Warren Buffett would just define it as permanent capital impairment--the odds that an asset's value will go down and never recover.
Those are pretty different notions.
Stipp: One of the things we know--especially [as it relates to] the investors-feeling-pain kind of risk, we have seen them react to that by doing what we would normally call a flight to safety, going into what's considered safe assets. And you argued that actually that’s a pretty expensive proposition right now.
Dorsey: It really is. I mean, when you just look at it right now, the price of safety is very, very high, whether it's 10-year Treasuries yielding under 2%. The German government recently auctioned six-month bonds at a negative rate. People are actually paying the German government to hold their money for them, which makes no sense whatsoever, in my view. AA and AAA corporates are yielding maybe 2.5%.
The risk here is that the investor doesn’t reach their goals investing in those assets. They'll make them feel better, because they won't bounce around very much in their portfolios, but even if you assume a pretty modest rate of inflation of say 3% over the next decade, Treasuries, high-grade corporates will not beat inflation, and you'll lose purchasing power.
Stipp: That, you would say, is the ultimate risk, right? You are not reaching that financial goal that you need to reach?
Dorsey: Exactly. I think it's fascinating that a lot of those risks ideas that we mentioned earlier, they all defined risk by the path that an investment takes--volatility of short-term returns--when the real risk is, I don’t have enough money to retire on. I have to send my kids to community college instead of a good school because I can't afford it, not because they are not smart enough. ... Or I can't pay the retirees out of my pension plan.
The risk that the money doesn’t do what you wanted it do, that’s a very real risk, and I think it’s a risk that some sort of myopic safety-seeking investors are ignoring right now. In their rush to basically dampen the volatility of their portfolios, they are ignoring the danger that over say five years or a decade or more, their money won't do what they need it to do.
Stipp: So this is a much more abstract risk to think about. But when you have seen losses in your portfolio over the last week or the last month, obviously that’s much more immediate to you...
Dorsey: Absolutely, it's visceral.
Stipp: What can I do basically to keep this more important risk, this longer-term risk, on my radar, and to keep from feeling quite so bad about some of this volatility and the ups and downs in the everyday market?
Dorsey: Well certainly first recognize that you are not being stupid acting this way; you are acting human. This is how we're wired as individuals.
Not checking your portfolios as often would probably be a good thing. I think it really does help people to stay focused on the long term when they are not checking their portfolio to see how it's reacting every single day. I think that’s a huge one.
Just being cognizant of the long-term effects of inflation--and that can just be a matter of either doing it yourself or asking your financial advisor to just show you some numbers. Say, if inflation is 3%, and my bonds do 2.5%, or inflation is 3% and my equities have dividends of 3% and you grow that dividend at a certain rate, how much do I have in 10 years? Look at the numbers. The numbers are the numbers. They are based on some assumptions, but you can see what they are.
So, for example, if you bought $1 million worth of bonds from Abbott Labs, J&J, Microsoft, and Wal-Mart right now--all wonderful businesses--yielding about 2.5% on average. Of course, that yield doesn’t grow at all.
If you assume a 3% inflation over the next decade, you will have $80,000 less in 10 years' time after adjusting for inflation.
If you buy the equities of those companies, and they raise dividends at a reasonably slower pace than they have over the past several years, you will have about $50,000 more after inflation. That is the price of safety.
Stipp: It's actually as stark as losing money versus gaining money for that safety, that feeling of safety to them?
Dorsey: Losing money after inflation. I think that’s what people forget many times.
What they say is, "Well, it's a bond issued by Microsoft or J&J" or whatever it might be ... "I'll get my money back." Yes, you will get your money back in today's dollars, but you will not necessarily get your money back in the dollars of 10 years from now.
Inflation is real, even at a 2% or 3% rate, it compounds quite a bit over a long period of time. And if you are thinking about college education, tuition inflation has run 6% a year for the past couple of decades. So you'd be even further in the hole, and that loss of purchasing power, again over longer time periods, can be very real and very painful for investors who don’t keep it in mind.
Stipp: The last thing that you had said to me, Pat, is the future for the investment, the future performance of the investment, is not going to depend on just what it did in the last month. You really have to look at something else before you invest.
Dorsey: Yes, exactly. The future returns you get depend on the price you pay today, not the returns you got over the past decade. It's that simple.
I think after a decade of pretty awful equity returns in the U.S.--because, of course, we were starting from very high valuations 10 years ago--it's natural to say, "Equities have been terrible over the past 10 years; bonds have been great. Why wouldn’t that continue?" But the past has nothing to do with the future when it comes to what returns an asset will generate. It all depends on the price you pay today and right now you are paying a very, very high price for safety. So the returns on safety are likely to be disappointing.
Stipp: Pat, some very critical insights on risk and how you frame it. Thanks for joining me today.
Dorsey: Always happy to be here.
Stipp: For Morningstar, I'm Jason Stipp. Thank for watching.
