Tuesday, June 9, 2015

Investment Risk May Not Be What You Think

A new logic has been surfacing amongst the top minds in the financial planning industry. Many of my favorite financial authors – Warren Buffett, Josh Brown, Nick Murray, Howard Marks, and others – have proposed the need to redefine the work “risk.”

Most investors and financial advisors tend to utilize the words “risk” and “volatility” interchangeably. We measure how risky a portfolio is by examining its potential downside performance. For example, we review how much a similar portfolio lost during 2008 or when the tech bubble popped in 2000-2002. When doing this, we are really talking about volatility rather than risk. Volatility – usually measured by standard deviation – reflects how much a portfolio is likely to increase or decrease in value when the market as a whole fluctuates. Risk, however, is quite different.

Josh Brown characterizes risk as the possibility of two threats:
  1. The possibility of not having enough money to fund a specific goal, which includes the possibility of outliving your money
  2. The possibility of a permanent loss of capital.
In a dramatic example of how volatility is different from risk, consider a retiree with a $10 million portfolio who only spends $50,000 a year. Next, assume the investor experiences a two-year period in which during the first year his portfolio loses 50% of its value and in year two the portfolio earns a 100% return. Thus, after year one the portfolio would only be worth $5 million and after year two it would again be worth $10 million.

Clearly, this is a very volatile portfolio that is subject to a wide range of potential performance outcomes. However, is this portfolio truly risky to the investor? According to Mr. Brown’s first factor, the portfolio is not risky because the investor will have enough money to fund his $50k per year retirement regardless of whether his portfolio is valued at $10 million or $5 million. Additionally, the portfolio is also not risky according to the second factor in that the investor didn’t experience a permanent loss.

Investors tend to view stocks as risky assets because they have a large standard deviation of returns. Similarly, we tend to view money market equivalents such as CDs and savings accounts as very safe investments because they are not likely to experience a large loss. However, rather than considering stocks to be risky and cash equivalents to be safe, it would be more accurate to consider stocks an investment with high volatility and cash to be a holding with low volatility.

What is the difference? Suppose it is determined that you need an average rate of return of 6% over time to achieve your retirement goals. Historically, over a sufficiently significant period of time, stocks have returned an average of about 10% per year while cash equivalents have returned about 3% per year. Consequently, if these averages continue in the future, you actually have a very low chance of reaching your retirement goal of not outliving your money if you place money in the “safe” investment of a cash equivalent, while you would actually have a pretty high probability of reaching your retirement goal if you place money in a more volatile basket of stocks.

By this metric, cash is actually the more risky investment because investing in it would increase the probability of outliving your funds. Meanwhile a basket of stocks, if given enough time to achieve its historically average rate of return, is actually the safer investment as it gives you a higher probability of not outliving your nest egg.  Thus, while a portfolio of stocks will almost certainly experience more short-term volatility, over an extended period of time it very well may be a safer investment for ensuring your retirement goals are met.

Warren Buffett recently addressed this issue in his annual letter to shareholders:

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

Further, Josh Brown proposes that the muddying of definition between risk and volatility is something a portion of the financial service industry has done on purpose. Mr. Brown suggests that the easiest way to sell someone a product is to first convince them they have a need. If hedge fund managers, insurance agents, and annuity salesmen can make consumers believe that volatility is equal to risk, and that since their products minimize volatility they must also minimize risk, they can achieve more sales. However, even if an annuity can eliminate downside volatility, if it limits potential return to a figure that is insufficient to achieve the investor’s long-term goals, the investment is still likely more risky than an investment with more short-term volatility but a higher probability of long-term success.

Next time the market goes through a correction, remember that the drop in your portfolio’s value is a reflection of the potential volatility your portfolio is capable of experiencing. Yet, recall that as long as you don’t sell your assets and suffer a permanent loss of your investment capital, you can allow the market time to recover and achieve its historical rate of return. Doing so will ultimately make your investment strategy less risky than utilizing investment options that experience less volatility because it maximizes the probability you will eventually achieve your long-term financial goals.

1 comment:

sianas regar said...

all certainly risky investments , but how do we minimize all possible risks that would have been possible.

basic concepts of investing