The Pricing of Risk: Yield Implications

Stop viewing Treasury yields from the perspective of opportunity.  For a moment, consider what they imply about the pricing of risk.  The concept, “I’m taking on more risk, therefore I need to earn more return” is often misapplied.  Perhaps it should be restated as such, “If you take on more risk, in order to justify that additional risk, your return needs be higher than the less risky investment just to be equivalent.”  Watch the interview below and try to ignore the investment-specific aspects: [RSS / Email Subscribers click through for media]

Instead of applying the conclusion that 10-year Treasuries are too risky because they do not generate X% yield, apply the correct interpretation that Treasury yields have about the future returns of riskier assets.  In other words, if 10-year Treasuries yielded 5% in 2006 and currently yield 3%, expectations of the future returns of more volatile assets (e.g. equities), should also decrease.  Think about it; if a “risk-free” asset once yielded 5% per year, riskier assets would need to return some higher percentage just to be equivalent.  If that same “risk-free” asset yields less today, do riskier assets need to make more or less return than they once did in order to justify the additional risk?

The value of returns is not simply about the end result, but it is also about the path the portfolio takes.  For instance, a 5% return can be much more valuable than a 7% return if the volatility of those return-paths is varied.  In my opinion, a perfectly consistent 5% annual return has a better profile than a 7% return which fluctuates between positive and negative performance.  These concepts aren’t built into too many portfolios.  Modern Portfolio Theory focuses on average historical returns without distinguishing between volatility, political environments, or societal adaptations.

Investment idea:  SHORT:  Old men whose discussion on portfolio strategy hasn’t been updated in 10 years.  While Jeff Applegate may be knowledgeable on various global topics, I lack confidence in his ability to maneuver portfolios through a volatile, low-return environment.  I disagree with most all of his portfolio-related thoughts, including: the “underweight / overweight” discussion, different investor profiles require a different investment selection, and of course, Treasuries should be purchased based on opportunity.

 

Ryan Lampkin is the Chief Investment Strategist at Castle Asset Management. Castle is an independent registered investment advisory firm whose focus is to transform the way clients view asset management.
 

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