Is following the crowd the biggest investment risk?

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In this episode of Connected Investor, Brunner Investment Trust's Julian Bishop and James Ashworth challenge conventional thinking about risk, arguing that the greatest danger isn't underperforming an index… it's the permanent loss of capital.

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James Ashworth (JA): I mean, if you are always following the market, you're always going to be a step behind I think it's very important to think independently.

Julian Bishop (JB): The analogy would be with roulette. If you play roulette, roughly you've got certain odds of landing on 24 or on red or black. In the real world, in the world of investment, you just simply don't know where the probabilities may end.

 

JB: Hello, and welcome to Connected Investor from the Brunner Investment Trust. I'm Julian Bishop

JA: and I'm James Ashworth.

JB: In investing we talk about risk all the time. But it's one of those words that can mean very different things to different people.

JA: For some people, risk is volatility or perhaps underperforming a benchmark. But for long term investors we think it's perhaps something quite different.

JB: So in this episode we want to explore a simple question, what if the real risk isn't standing apart from the crowd but following it? So, James, when we talk about risk in investment, what do we actually mean?

JA: It's a great question. And the answer is unfortunately not very simple. For many people, risk is about performance relative to a benchmark. Many investors are tracked on their performance relative to an index, maybe the S&P 500 or the FTSE 100. And for many investors, they think about the risk as the risk of performing worse than that benchmark. Other investors will think about risk as volatility, literally how much their portfolio or their asset goes up or down in value. But for us, as long-term investors, we think that actually the most important thing, the risk we really care about is the risk of losing money permanently, permanent impairment of capital.

JB: Yep. So investing is all about growing, but also maintaining your capital. And in the investment world you have something called relative risk, which is how you think about your investment performance versus a benchmark. And you have absolute risk, which is actually the risk of losing a lot of money. And those two things can point you in very different directions.

JA: Yes, absolutely. And they can sometimes be in real stark contrast. And it's quite easy in many ways to reduce relative risk. If you're an investor who is tracked relative to a benchmark, you can reduce relative risk to nothing by just replicating the benchmark. And that's what an index fund will do. But at the same time, if you do that, there may be positions and stocks that you buy that you actually don't believe in. You don't think are attractive investments. And so, you might be actually increasing your absolute risk by buying these equities, these shares in companies that you don't believe in and you don't think you're attractive investments just because by doing so you reduce so-called relative risk.

JB: I seem to remember a conversation I had with a risk department at a former employer, and they said to reduce risk, meaning relative risk, you need to buy all these things. And then they pointed to me towards a bunch of what I thought were very, very fundamentally risky equities. And I think that sort of tells a story. A lot of the industry is focused on this notion of relative risk as opposed to absolute risk. And that becomes more pertinent the more concentrated indices become. So, one of the stark features of the US market, for example, at the moment, is that the top ten holdings in the S&P 500 now account for almost 40% of the entire benchmark. So, you think when you're buying a benchmark or when you think about an index, you think about owning a little bit of everything. But in fact, if those companies become so big and if certain sectors become so significant, you lose that diversification benefit. So, ten stocks from the S&P 500 account for about 40% of its value. The S&P for 90 accounts for the other 60%. So obviously you're getting to a point here where the index the benchmark is getting more and more risky.

JA: Yeah that's a that's a really interesting point as well because not only is the index getting more concentrated, but it’s also getting concentrated in a in a single sector effectively for most of those ten largest businesses that you highlight are technology companies. Add that concentration with roughly 40% of the market being made up by those top ten companies is much higher than it has been in history in the US for most of the last few decades or half century. The top ten companies may have been 20 or 25% of the index, and it would be quite diversified between industries. You had GE, you had Microsoft, you had ExxonMobil, you had a broad swathe of American business and industry. But as you say, you know, it's becoming much more concentrated and it's becoming more concentrated in a small number of, or in a single sector, effectively. And we could go even more extreme here if you if you rewind back to the.com boom. I remember at the height of the.com boom, Nokia the handset maker that was dominant in, in old fashioned, what we now call dumb phones. But at the time we just called mobile phones. You know at one point represented about 70% of the Finnish stock market. Now going back to absolute and relative risk. You know, the way to reduce or eliminate relative risk was to buy 70% of your portfolio into Nokia. At that point, you would perform broadly in line with the index because whether a Nokia went up or down, your stake in Nokia would go up or down to commensurate degree.

So, you might have thought you'd eliminated risk. You thought you'd eliminated your relative risk. But unfortunately, we all know what happened to Nokia, it doesn't really exist as a handset manufacturer anymore. The shares fell from €55 to, I think, about €1.50. So, you had huge absolute risk. So that's a key lesson for investors that you can think you're reducing or eliminating relative risk, but at the same time carrying and bearing huge absolute risk.

JB: I think one thing we're keen to point out at the moment is that the Brunner Investment Trust is considerably more diverse these days than the S&P 500 which is an inversion of where things would have been in the past. Typically, in the past it would have been more concentrated than the index. So, what we're seeing really is this concentration in markets, a lot of which is around technology, specifically around AI at the moment, which means that a lot of investors are inadvertently taking a lot of absolute risk. In short, if this whole AI thing doesn't plan out the way people are hoping, they're going to lose a lot of money.

JA: Yeah, you could have very low relative risk, but still lose a lot of money.

JB: Absolutely.

JA: So if the benchmark is becoming increasingly concentrated and not representative, maybe of the broader market. What do you what do you think investors should be doing?

JB: I think it comes down to a determination to think independently, not just to follow the herd, being willing to look different from what everybody else is, is doing. I think at all times it's important to diversify the old adage, just do not put all your eggs in one basket. Simply because other people are doing so doesn't mean it's appropriate for you to do so. One thing we aim to do at Brunner is to seek out as many uncorrelated risks as possible, and that might mean accepting that you will underperform at times. You're going to be different from the benchmark. That will mean that your performance deviates from the benchmark. And that's not necessarily a problem. As long as you communicate to your shareholders, to your clients what you're doing and why, and you do it with, good logic and soundness.

JB: I think that's a good way to run money, but it's not always comfortable.

JA: I mean, if you are always following the market, you're always going to be a step behind. I think it's very important to think independently. Recognise these narratives that grip markets can be very persuasive, very powerful. But they often don't last forever. You know, whether we go back and look at what we already talked about with the dotcom period. You know, the internet changed everyone's lives more than people could possibly imagine. Its 25 or 30 years ago. But it's still, it became a very significant point of people bearing huge, absolute risk thinking they're running low relative risk as we went through the, the dotcom crash effectively.

JB: It's worth noting that markets are still, to a large extent, driven by human beings, and human beings have foibles. there's a lot of comfort being in the herd. There's a lot of pressure to do what other people are doing. There's greed, there's fear. There's the career risk, frankly, that can come with underperforming and trying to think differently. That's an enormous pressure that affects a lot of fund managers. And it's important, I think, at times just to be able to step back from the fray. Invest in a way that you think is sensible, avoiding concentrating too much of your capital in one area, and particularly at times where the market seems to be acting in a very speculative way.

JA: Yes I think the career risk point is a is a really strong and important one to bear in mind. I mean, there's a great quote from John Maynard Keynes decades and decades ago, who said ‘worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.’ And for many people in positions such as ours, it's better just to follow the herd. And I know you've seen a great cartoon of a load of lemmings jumping off a cliff and a lemming halfway to the back saying, I don't know where we're going, but I'm sure it's great. And it's really popular and clearly following the herd. It feels very safe, but it may lead you to take a significant absolute risk that you don't want to bear.

JB: So I think there's a deeper point here about how we think about risk more broadly. It's not just a number. It doesn't actually follow a neat probability distribution, either. In the real world, outcomes are uncertain and sometimes unknowable. So, this is where you get into this whole world of, black swans. And Donald Rumsfeld's speech about known and knowns and unknown unknowns and so on. But I believe it's what philosophers would call radical uncertainty. So, this simple idea that you don't know what the range of possible outcomes is. So, an analogy would be with roulette. If you play roulette, roughly you've got certain odds of landing on 24 or on red or on black or losing your money if it falls on green.

JB: In the real world, in the world of investment. your ball might fall on red. It might fall on black. It might fall on 21, but equally, it might fall on blue or 72 or a banana. You just simply don't know where the probabilities may, may end. You're dealing with a set of risks that you can't possibly, envisage.

JA: Yes. So, when we think about constructing a portfolio, bearing in mind that these risks, I think the important thing to remember is we're always looking for businesses with strong competitive advantages. Significant cash flow generation. And where those risks are uncorrelated. So, we don't want to have 20 stocks that are all exposed to the same risk factor or the same story. And if you look at many of the businesses we own, whether it's UK car insurance or manufacturing semiconductors in Taiwan or UK grocery, retail or hotels in the US, they are what we might classify as uncorrelated cash flow streams. Now, no doubt there will be some correlation between them. But the correlation is hopefully not high. And if there is an event or a risk, we try to diversify away as much of the as many of the risk factors as we can by having a broad portfolio of, of high quality businesses.

JB: Yes, so it's very hard to see how the profitability of a UK car insurer relates to the profitability of an American hotel or a Taiwanese semiconductor manufacturer.

JA: Exactly.

JB: Whereas if you look at the S&P 500, for example, the profits of Nvidia are linked to the profits of Amazon, which are linked to the profits of Taiwan Semi. A lot of these huge mega cap names now are correlated around one risk. And at the moment, just to bring it down to a nutshell, that risk is AI this huge boom in infrastructure expenditure. And probably the most important question at the moment, I think, for global markets is whether this boom in CapEx proves sustainable. And it may do, but there are lots of reasons to think why there's a bit of a mania here.

JB: It may prove unsustainable, in which case now is not the time to bet the farm.

JA: So maybe, Julian, if we come back to the central question, the question where we started, you know, what would you say is the key takeaway for investors as they think about risk?

JB: I think sometimes you need to think about what the herd's doing. Be willing to stand away from the herd, embrace uncorrelated risks so that no matter what happens, you'll be making you'll be making money. I think increasingly it's really important at the moment to be willing to stand apart from the fray to rise above the market. I think all of those things are important. Ultimately, we see the portfolio as a series of businesses that are all generating cash. We want them to be robust cash flow streams growing, uncorrelated, relatively low risk. And as far as we can tell. And if you do that, ultimately, you'll have good investment outcomes.

JA: Completely agree with you I think that's a great summary. Great to chat as always Julian.

JB: Thank you James. And thank you for watching and listening to Connected Investor. If you enjoyed this episode, do follow or subscribe and we'll see you next time. Thank you.

JA: Thank you.