“Certain defeat results from any strategy whose aim is to win rather than avoid losing”
–Richard Berstein, Against the Gods
Each dollar you invest can be viewed as a player in a game. You can not continue playing the game if you run out of players. It is paramount that, as investors, we make sure to take advantage of opportunities as they arrive, and this is only possible is we have capital to deploy. In the current state of our investing world, it is clear that investors are taking more risk than necessary, namely because the risk-free rate of interest is so low. As examples, high yield bond spreads are historically tight, meaning that people are buying up junk bonds even though they offer very little in the way of compensation. As more proof that risk has become an afterthought, the percentage of covenant-light fixed income securities (lacking investor safeguards) is climbing at a significant clip.
Risk is usually defined as standard deviation, but wise investors are willing to take on massive standard deviations because they view risk as permanent loss of principal. The CBOE Volatility index, VIX for short, is at all time lows and seems to be stuck there. This means that “risk” (read standard deviation) is expected to be low in the near future. Is this due to everyone reaching for yield and no one looking to sell?
On top of these examples, the yield curve keeps flattening- and we all know what that could mean; This could end poorly for the return-oriented among us.
As Bernstein notes further in his book, “Our challenge is to first not take more risk than we need to generate the return that is offered.”
Sources: WSJ Daily Shot, Against the Gods