Conservation of Risk

Is the market getting too risky?

GameStop gift card. Photo: Doug Tengdin

Everybody has questions about GameStop, Bitcoin, Tesla, hedge funds, and the daily volatility that keeps us on edge. Is this like the dot-com bubble? Is everything overpriced? And how can stocks be roaring when the economy is stuck in a lockdown?

Investors are caught in an information dilemma: everything we know is based on the past; but everything that matters depends on the future. The more uncertain the future, the more volatile asset prices will be. The future of a US Treasury note is pretty boring, the bond pays interest and then matures. The only question is what interest rates do in the meantime. Similarly, the future of an almost-defunct mall-based store that sells video games seemed pretty boring as well. GameStop was just another victim of our everything-online world, until a flash-mob of retail investors decided otherwise.

GameStop share price. Source: Bloomberg.

In the short run, volatility depends on investors’ sentiment: what we like, what we worry about, what we avoid. In the long run, investment value depends on future cash flows.

Bonds are a senior claim on cash flow. If a company doesn’t pay what it owes, bondholders can control of the company’s assets and get (some of) their money back. That’s why Lehman’s bondholders got 35 cents on the dollar. At least they got something.

Stocks are a residual claim on cash flow. Lehman’s stockholders got nothing, just like Washington Mutual, JC Penny, or MCI. Stocks can grow, but they’re also risky. And their risk is proportional to the price: the more we pay, the more we have at risk. GameStop is less risky now than it was a week ago, but more than it was three months ago.

Volatility is a pretty good measure of risk, which can also be described as “the chance of something going wrong.” When you own a Treasury Note, there’s not much that can go wrong. Especially compared with a stake in an almost-bankrupt video game store. The degree of riskiness is inherent in the investment. When we buy a publicly traded investment, falling prices mean something is going wrong – at least for us. Volatility quantifies the jumpiness in prices.

S&P 500 volatility. Source: Bloomberg

Risk is conserved. It never really disappears, it just migrates from one place to another. The economy may be volatile because of Covid, while the stock market makes new highs. Then investors start worrying about the reopening igniting inflation, which drives interest rates higher. Higher rates settle in, the bond market settles down, but this upsets growth darlings like Amazon and Zoom which depend on squeezing growth out of a no-growth economy. They’re so big that that their shares have a huge impact on the entire market. And so the cycle turns.

Conservation of risk in the market is like conservation of matter in the universe. It may not be clearly visible – the market has “dark volatility” just like the universe has “dark matter.” But all risk has an impact, whether we see it or not.