Investing is risky. That’s no secret. But I find that many investors get fixated on the elements of risk that matter least and ignore the risks that matter most. When I meet with new clients I try to focus the discussion on the real and personal side of risk, not on textbook definitions.
The best measure: Shortfall risk
We define the primary risk for individual investors as falling short of long-term financial goals. All the fancy portfolio metrics just don’t matter much when you reach a point in your life where you can’t afford to do the things you desire for yourself, your family, important philanthropic causes and future generations.
That’s why we practice goal-based asset management. It’s our job to customize a diversified, tax-efficient index portfolio that provides each client the best opportunity to reach his or her unique financial goals. As we described in last week’s article, there is a “safe and sound number” for each investor – a long-term annualized return that provides for all future cash flows. Falling short of that number over the long term is an investor’s greatest risk.
The next measure: Needless peril risk
Our next measure of risk is needless exposure to financial danger. We all know that you have to take risk to expect a return. But you should not have to take risk out of proportion to your desired return. Ten percent might sound like a nice return but not if the riskiness of the portfolio warranted a 20 percent return.
Avoiding needless peril risk is all about asset allocation. An optimized allocation maximizes expected return for any level of expected risk. To achieve this balance between risk and return, we use the data, computing power and PhD resources of Windham. Linking risk and return is vital in portfolio management; you can’t do one without the other.
The weakest measure: Volatility risk
Volatility is the most common and, to my eye, the least valuable risk measure. Volatility describes the ups and downs that a security or portfolio experiences. It has a couple real limitations. First it is primarily a short-term measure in a long-term world. If you are investing for goals 10, 20 or 30 years in the future, daily or monthly dips and spikes just don’t make much difference. With thoughtful cash flow planning guiding asset selection, there should always be plenty of liquidity available, regardless of short-term return fluctuations.
Second, volatility is a number, not a feeling. Often expressed as the standard deviation of annual return, volatility is a number that conveys little to most investors.
Investors should expect volatility but they don’t need to fear it. In fact, they should embrace it. The volatility of riskier investments (such as stocks) is what allows investors to earn higher returns than non-volatile investments (such as money markets).
Risk is personal
How should risk be measured in your portfolio? That’s really a personal matter, an important idea for you to discuss with your investment advisor. What worries you about the markets and your financial future? What can you live with, and what can’t you live without? These critical questions – that only you can answer – will shape how your portfolio is built and managed.