A Fresh Look at Risk

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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.

 


 

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This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Nothing in this article is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.

Any references to third-party data or opinions are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client’s or a prospective client’s needs and objectives.

Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.

 

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