(part one of three)

Physicist Werner Heisenberg noted that in order to measure or "see" the position of a particle, a physicist has to literally bounce other particles off of it, thus altering the measured particle's velocity. His statement — "the more precisely the position is determined, the less precisely the momentum is known" —  is the basis of the oft-misquoted "Uncertainty Principle". In order to see the world objectively, we must understand the impact of our observations. Investment markets may only occasionally resemble sub-atomic physics, but Heisenberg's caution about observer interference is relevant to investment risk assessment¹.

The risk of earthquakes, floods or tornados may not change much over time, but our ability to measure and assess them does. Therefore, a perception of increased risk is usually a new perception of a static or objective reality. In other words, the fact that we may all worry about an increased likelihood of an earthquake does not increase the probability of an earthquake. Investment markets and other social constructs are different. As participants in the investment markets, our perception of risk can affect the actual risk in the market. Similarly, society's perceptions of acceptable assumed risk may affect the settlement or litigation of a liability claim. Our assessment of risk forces us to reprice it, and that repricing of risk then alters the very data from which we calculate risk. Investors themselves (as a group, rather than individually) create and reduce risk.

As we consider the state of the market and whether it exaggerates or understates the underlying fundamental risk, bear this question in mind: What role have investors played in today's perceived financial market risk?

The Risk Penalty?

Reaching out to clients in a conference call after the vile atrocities committed on September 11, 2001, our Chief Investment Officer Jeff Schoenfeld suggested that the markets would "see the world as a riskier place". This turned out to be an understatement. The markets have repriced risk across the spectrum to such a degree that the top-performing assets over the last ten years are now "risk-free" obligations of the U.S. Treasury.

Going back to our insurance analogy, this is a "hard market", indicating that the price demanded for risk assumption has increased. The underlying risks also appear to have increased. For instance, the risk to urban property (and life) increased or was made manifest by September 11 and jury awards continue to grow, affecting most liability lines. On the other hand, "hard pricing" is also a function of diminished insurance capital. After all, the real risk of terrorism was likely greater on September 10, 2001 than over the last year.

We face a similar situation in the investment markets: risk premiums have skyrocketed, and the underlying investment risk is, if not greater, more evident. For instance, as I write, the average A-rated corporate debt obligation demands a premium of nearly 2% over a comparable maturity U.S. Treasury Note. We estimate this spread is more than double the amount of return necessary to compensate investors for the long-term default and downgrade risk of the single-A category. The same relationship is evident in the high yield market, where B-rated securities trade at a 10% premium to U.S. Treasuries in an environment where the default rate is around 9%². This spread was slightly lower in late 1991 when defaults peaked at 13%.

Bonds constitute only part of the substantial changes in the relationship between risk and reward. The most dramatic illustration of the market's sea-change is shown in the following graph, which describes the trailing ten-year returns of various domestic asset classes. For most of the history of the financial markets, asset classes with higher risk produced greater long-term returns than those with less risk. Yet, over the last three years, like periods in the 30's, '70s and early '90s, these relationships have reversed, and return experience has been inversely correlated with risk.

Is this because, like rocks at low tide, risks that have been there all along are merely more visible? Or is it because the confluence of "unusual events" over the last few years indicates an actual increase in the fundamental economic risks underlying the financial markets?

In part two, we compare the risk in the markets to the underlying risk in the economy, and discuss the enormous divergence between the two.

1. In one famous case where investment management had indeed come to resemble particle physics, even the Nobel Prize-wining principles of Long Term Capital Management failed to consider the impact their trading had upon the efficiency of the markets that they "arbitraged".

2. Source: Moody's trailing 12 month default rate, equal weighted.