The big fall in Apple’s share price recently reminds us of an underappreciated type of risk that almost all investors face – one that has been called earthquake risk.
Some areas are prone to earthquakes, but scientists cannot accurately predict when they’ll strike. People living in such areas can therefore be reasonably safe in the near term (because the probability of disaster is tiny in say the next week), while facing a near-certain catastrophe in the long term.
Many assets are like this – safe or attractive in the short term, but dangerous in the long. The most egregious example of this was the XIV exchange traded note (ETN), which was in essence a bet on US stock market volatility staying low. It paid off wonderfully well in 2016-17 when markets were stable. But it became worthless in 2018 when volatility rose. And that was only to be expected. Its issuer, Credit Suisse, explicitly warned investors that the note could become worthless if volatility rose and told its holders to regard it as only a short-term investment. Holding it was like living in an earthquake-prone region – a pleasant experience for a while, but one certain to end in disaster.
All growth stocks face a (usually) milder version of this risk. No company can grow faster than the economy forever – if it did it would eventually become bigger than the economy, which is absurd. All of them must therefore eventually encounter Stein’s law, named after an economic adviser to Richard Nixon: “If something cannot go on forever, it will stop." Growth must therefore slow, and when it does share prices will be hard hit. As Apple’s investors have found, even the strongest company will eventually run into market saturation and resistance to price rises. When this happens share prices can fall a lot. Apple differs from other companies only in that it succeeded in postponing this day for so long. For many other growth stocks, the transition to slower growth comes sooner and nastier.
It’s not just growth stocks that face this danger. So do most shares. Less than one-third of the members of the FTSE 100 when the index was launched in 1984 are still independent listed companies: it would be fewer still had banks not been bailed out in 2008. This tells us that many companies will in the long run be on the wrong end of what Joseph Schumpeter called "creative destruction": HMV is just the latest high-profile casualty of this process. In fact, Hendrik Bessembinder at Arizona State University has calculated that most US shares that have ever existed have underperformed cash during their lifetimes.
Most stocks, then, are like that XIV ETN. They might be decent short-term investments, but they are destined for trouble eventually.
This is true in other senses. Every day brings us nearer to a recession when cyclical stocks will be hit hard. Before then, however, such stocks could do well simply to compensate for this risk. We’ve known for months that China’s economy would cool off (because slower growth in the money stock is a good lead indicator), but investors ignored this fact for most of last year – until they suddenly woke up to it.
A similar thing happens during credit-fuelled booms. Everybody knows (or should know) that the boom will turn to bust eventually, but they ignore this and load up with risk. As Charles Prince, then chief executive of Citi famously said in 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.”
All this tells us that the long term is not merely a succession of short terms. Strategies that can pay off nicely in the short run are almost certain to do horribly in the long. The investment world in (say) 30 years’ time will be very different from today’s, in the sense that our idea of what are dominant blue-chip companies will be completely different from today’s. Just as a town built on a fault line might look much the same next month as it does now, but will be completely different in many years’ time, the same is true of investing.
What I’m saying here contradicts the conventional wisdom about shares, which is that they are a safer long-term investment than short-term one. This is wrong. Some risks do diminish over time: if you toss a coin enough times, it will eventually turn up very close to 50 per cent heads. On the other hand, though, others become uncertainties: a 1 per cent chance of disaster in a month multiplies to a 70 per cent probability of one in 10 years.
What's more, there's a distinction between risk and uncertainty: risk is a known probability; uncertainty an unknown one. And uncertainty increases with time: we can be reasonably confident that a company will survive the next month, but not the next 50 years because we cannot predict whether technology will change to render it obsolete as it did to Kodak, Polaroid or Nokia.
You cannot be a genuine long-term stockpicker because the stocks you’re holding today might well not survive to see the long term. In one episode of The Simpsons, Mr Burns blows the dust off his stock portfolio to find that it contains shares such as Confederated Slaveholdings, Amalgamated Spats and the Baltimore Opera Hat Company. That’s the fate of long-term investors.
For me, this is another virtue of tracker funds. In holding the entire market – ideally the global market – these help to diversify away earthquake risk by ensuring that we have exposure to the general market rather than to companies that have only short-term futures.
