Are Investors Focused on the Wrong Risks?

On the back of small losses on Thursday, stocks rebounded on Friday, with the S&P 500 (SNPINDEX: ^GSPC  ) , and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) gaining 0.6% and 0.4%, respectively. The VIX Index (VOLATILITYINDICES: ^VIX  )  -- Wall Street's fear gauge -- dropped 3.6%, to close just above 13. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming thirty days.)

The other octogenarian worth listening to
In a society that worships at the altar of youth, there are still a few octogenarians who manage to make headlines in the investing world. Berkshire Hathaway's Warren Buffett and Charlie Munger are at the top of that list (although Mr. Munger will soon be a nonagenarian), and Vanguard Group founder Jack Bogle is certainly on it, too. While many investors are focused on this month or this year, in a game in which secular cycles can last 10, 20, or 30 years (and sometimes longer still!), it's useful to get the perspective of someone who has been playing for six-odd decades.

One of the near-term risks that has elicited much coverage and hand-wringing (including from me) is the "fiscal cliff." On that front, Bogle isn't worried. As he said in a video interview published on Yahoo! Finance on Friday

It would be a much bigger risk if markets weren't reasonably valued and I think you can say that the stock market is at a reasonable valuation. It's really all going to get worked out sooner or later anyway, so I'm pretty confident that that is not the source of our big risk.

"What I worry about are the known risks that we don't pay much attention to," he goes on to say. The "known unknowns" he cites are nuclear proliferation, a global pandemic, and war. I don't disagree with him, but how does one hedge those risks? Deep out-of-the money puts on stocks? Treasury bonds? Gold? Guns and water?

I think the best way to prepare for such risks might be to carefully think through what one might do if such risks were to materialize, and to remain mindful of signs that these risks are increasing. Otherwise, actively hedging such small-probability outcomes can be quite expensive, as GMO strategist James Montier pointed out in A Value Investor's Perspective on Tail Risk Protection.

One last point: Investors may want to dial down their expectations. While Bogle thinks the market is reasonably valued, investors may find that translates into a disappointing return forecast:

Let's just say in the next ten years – which I don't think is going to be a bad number -- [the market produces] around a 7% return on stocks, so if you buy and hold, you're going to get that 7%.

He remains  true to the buy-and-hold approach he helped popularize.

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