Talking Indexes
By David Blitzer

The end of the year is almost in sight, and pretty soon we will see a flood of articles taking stock of how the markets did in 2006. Did the U.S. lag Europe or Asia? Is Japan really reviving? Will China's markets finally reflect its economy? Was this the year when large caps finally caught up to small caps? Did this new "enhanced" or "fundamental" index beat that old market-cap index, or vice versa?

Among all the questions are one or two things we can be confident about. Since far more often than not a majority of active mutual funds trail their benchmarks, this is likely to have been true again in 2006. And if history is any guide, we will see complex explanations why active funds lagged again, as opposed to the simpler idea that costs and operating expenses make a bigger difference than most people realize. Regardless, people will celebrate all the newest financial innovations in the market.

Among all this chatter and talk of progress, however, there is one critical area where little progress was made, whether one looks at 2006 or the last several years: managing risk.

For any investment beyond T-bills or short-maturity TIPS, risk and return come packaged together. Despite claims to the contrary, returns get all the attention and risk gets little more than lip service. Maybe that's because investments sales are based on greed, and returns feed greed while risks feed fear. Returns are easier to explain and understand, and because predictions sound more convincing, they make for a faster sale. Risk is at least as important as returns, however, and probably more so; it is something we should have learned a lot about in the last decade or so.

Investment guides all emphasize the power of compound interest, and how an extra half-a-percent return each year means a lot more money after 20 years. Where are the investment guides talking about the importance of shrinking the worst year from negative 25 percent to negative10 percent, or, better yet, avoiding that year altogether? That kind of investment guide might be more helpful to the average investor. Then again, it probably wouldn't sell very well: talking about losing money is no fun.

Through the tidal wave of new investment products that have come ashore in recent years, very few help investors understand or manage risk. Among the few exceptions in the index arena are the CBOE Volatility Index (VIX) and the CBOE S&P 500 BuyWrite Index (BXM), both of which are combinations of indexes, investment mathematics and derivatives. VIX measures the option-implied volatility of the S&P 500. It can be traded on Chicago Board Options Exchange (CBOE) and has a consistent negative correlation with the S&P 500 that certainly suggests some ways to manage downside risk. BXM, in turn, measures the performance of a strategy of writing covered calls, and probably says more about returns than about risk, though it does show how to profit from the other fellow's appetite for risk. It too can be traded. While both of these original risk measurements were based on the S&P 500, they have now spread to other indexes as well.

The current decade should be the golden age for risk-based investment products. First, unless investors have extremely short memories, they should still be able to recall the 2000-2002 bear market. If they need comparisons, there is the late-1990s bull market. These memories should hint at the answer to the earlier question about the benefits of suffering a 10 percent loss instead of a 25 percent loss. While I haven't met anyone who believes that the markets did not drop over 20 percent in a day on October 19th, 1987, that event vanished from most discussions about investing when its tenth anniversary passed. In fact, what most investment professionals-and virtually all investment product sales people- recall about 1987 is that the S&P 500 total return in 1987 was positive, despite the crash. Funny how memory works.

Understanding risk is much more than recognizing that market prices can fall as well as rise. Understanding risk seems to have two broad components: cataloging what might happen to an investment and considering how investors would react to it. In the first area there has been a lot of progress, some of which has found its way into new investment products. Risk comes in many guises - market risk, credit risk, counterparty risk, political risk and much more. While investments are primarily concerned with market risk, the others are worth a brief note here. Credit risk is an area where investment products have made huge strides, through credit default swaps. These are a recent example of using statistics, the law of large numbers and ingenuity to create securities and trade risks. David Ricardo's economics of comparative advantage explained how countries benefit from international trade; it also explains how credit default swaps let those who can afford risk trade with those who can't. Another example is catastrophe bonds for natural disasters and, presumably, for some difficult-to-insure political risks as well.

Dealing successfully with most risks, and certainly with investment risks, depends on understanding how people react to risk. One reason why we should be in a golden age of risk-based products is the growing interest and research in behavioral finance. I don't have a date for the invention or introduction of behavioral finance, but almost any date or founding article I might mention would bring forth claims of earlier developments, probably with citations to John Maynard Keynes, Adam Smith or possibly the Bible.

There are some ideas from behavioral finance that people seem to agree on, and which should help develop some investment products. One is that investors rarely behave as fully rational calculators making optimal choices based on statistics, economics and finance. They play hunches, make forecasts based on limited analyses, favor the familiar options over things that seem foreign, and fail to diversify away risks when they can. While investors fears losses far more than they value gains, these habits leave them with more risk than they realize. Despite all this, there is little progress on the product front to help cure some of these ailments. One bit of progress that is worth noting is a growing practice among 401(k) plans to improve the default options-where a participant's contributions are invested if he or she fails to create an asset allocation. No longer is the default always the money market fund, which was a bad choice for many participants, as 401(k)s are often long-term investments.

In looking forward rather than back, one hopes to see new investment products and investment progress addressing risk in light of the lessons of behavioral finance. Helping investors avoid the worst mistakes may return a lot more than that extra half-a-percent a year from a new idea with a higher fee. For now, index investing may be the closest to some of these ideas, covering diversification, recognition of how difficult forecasting is, low costs and the thought that the only hunch worth following is that there aren't any hunches worth following. Hmm … maybe we're on to something.