You know the feeling. You hear noisy headlines trumpeting the latest Default, Plunge, Scandal, or Imminent Crisis. Your heart rate quickens. You wonder if you’re in danger. You feel, depending on your personality, paralyzed by doubt, or compelled to do something…anything.
That white-knuckle feeling is about investment risk and uncertainty. But what is risk, really? The definition you choose has a big impact on what you should worry about and what you can just ignore.
Risk is often expressed as a number. It may be labeled standard deviation or volatility. Either way, it essentially measures how widely the return of an investment (or portfolio) is expected to vary from “normal.”
If the average annual return of a security is 7 percent, but over time bounces around from +25 percent to -25 percent, this would be considered far more risky than a bond that paid +4 percent every single year and promised to return all your money. That’s higher volatility, which means more risk.
Though accurate and valid, there are problems with trying to capture risk in a number. First, the numbers may not convey much meaning. How high a standard deviation is too high? Unless you loved math in college, it may be difficult to translate the statistics into real life decisions about investments.
Further, historical patterns may not translate to future results. Generally we see a long-term connection between risk and return. To earn higher returns you generally need to take on more risk. But over a short timeframe, there may be no connection at all between risk and return. A statistically risky portfolio, for example, may generate modest and boring returns for years on end, or vice versa.
Another way risk is sometimes framed revolves around liquidity – the ability to get out or to make portfolio changes. Investments that can be easily sold without fear of losing money are considered safe. Unfortunately, as we all were reminded in 2008, few such investments exist.
Liquidity is not much of an issue for most investments. Our expansive markets make it easy to find a buyer for stocks, bonds, ETFs and mutual funds. However, to sell out one may have to accept a price steeply discounted from the original purchase price.
Like volatility, this fear of being stranded is surely a valid definition of risk, but again it is not very useful. Individuals typically do not need all their money at once, and a disciplined investment plan rarely includes a strategy like: “Sell all my stocks; I can’t take it anymore!” If a portfolio can only be successful if it never ever falls in price, it’s probably the wrong portfolio.
Of course, bailing out completely is a risk in itself. As awful as 2008-09 was, those who held on ended pretty much where they started, while many who sold out had to buy back in at higher prices later on.
If not volatility and not liquidity, then what? How should the individual investor think about risk?
I feel strongly that the most relevant risk measure is the possibility of not reaching one’s goals. There’s little point in suffering sleepless nights and stomach aches over the standard deviation of your investment portfolio. What matters is whether you will be able to fulfill your financial commitments to your family, retire comfortably, and see the rest of your financial desires fulfilled.
That’s why we practice goal-based investing at Osbon Capital. Long before we begin to consider what investments make sense for a client, we focus on the desired outcomes and then tie every buy or sell investment decision into them.
Goals can be stated in many ways, but must be specific. “$10 million at retirement.” “Enough so I don’t ever have to take a job again.” “Retirement at my current standard of living and one million for each of my kids.” “Staying ahead of inflation by three percent a year.” “Six percent annualized return over my lifetime.” I’ve heard these and others, and they are valid, workable goals.
Only when the goal is clearly articulated can your investment advisor begin measuring and crafting a portfolio to reach it, applying the fundamentals of portfolio management – asset allocation, diversification, cost control, and tax awareness.
Beating the Dow has nothing to do with it (“Hey, I beat the Dow in 2008, my stocks were only down 30 percent!”). Managing to one’s personal investment goals becomes the relevant risk metric. Are you on your way? Are you achieving the goal? How much farther? How much longer? Have your goals changed?
These are the questions we ask at Osbon Capital when we talk about risk. They have nothing to do with headlines and white knuckles. They have everything to do with you.
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.
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