Gallery:Step 10|Step 10: Risk Capacity

Risk: What Exactly Is It?

Gallery:Step 10|Step 10: Risk Capacity

Risk: What Exactly Is It?

Since none of us can clearly see into the future, achieving an accurate assessment of risk and its related expected returns is a cornerstone of prudent investing. But first it is important to define what exactly is meant by “risk.” Risk takes on many guises and can be different things to different people.

Variations on Standard Deviation

The most commonly used academic definition of risk is standard deviation — a measure of volatility. But it is important to recognize that two investments with similar standard deviations can experience entirely different distribution of returns. While some investments exhibit normal distribution (i.e., the familiar bell curve), others may exhibit characteristics known as “kurtosis” and “skewness.” We will first define these terms and then explain why it is important to understand their implications.

Skewness measures asymmetry of a distribution. In other words, the historical pattern of returns does not resemble a normal (i.e., bell-curve) distribution. Negative skewness occurs when the values to the left of (less than) the mean are fewer but farther from the mean than are values to the right. For example: the return series of –30 percent, 5 percent, 10 percent, and 15 percent has a mean of 0 percent. There is only one return less than zero percent, and three higher; but the one that is negative is much farther from zero than the positive ones. (Positive skewness occurs when the values to the right of [more than] the mean are fewer but farther from the mean than are values to the left of the mean.)

Behavioral finance studies have found that, in general, investors prefer assets with positive skewness. This is evidenced by their willingness to accept low or even negative expected returns when an asset exhibits positive skewness. A classic example is the lottery ticket, where the odds of winning the jackpot are extremely low, but the few times it does occur, the winnings are extremely high. At the same time investors generally avoid assets with negative skewness. High-risk asset classes (such as junk bonds or emerging markets) typically exhibit negative skewness, as do some investment vehicles such as hedge funds.

Kurtosis measures the degree to which exceptional values — those much larger or smaller than the average — occur more frequently (high kurtosis) or less frequently (low kurtosis) than in a July 2003 normal (bell shaped) distribution. High kurtosis results in exceptional values that are called “fat tails.” Fat tails indicate a higher percentage of very low and very high returns than would be expected with a normal distribution. (Low kurtosis results in “thinner tails,” with a subnormal percentage of very low and very high returns.)

When skewness and kurtosis are present (the distribution of returns is not normal), if we look only at the standard deviation of returns, we may underestimate the risk involved in investing in an asset class. This creates particular problems for those using what are known as efficient frontier models to help them determine the “correct,” or most efficient, asset allocation.

Efficient frontier models are based on mean variance analysis, which assumes that investors care only about expected returns and standard deviation, and do not care about whether an asset exhibits skewness or kurtosis. If it were true that investors were not affected by skewness and fat tails, then, indeed, the use of mean variance analysis would be appropriate (although we feel there are other serious problems with the use of efficient frontier models that are beyond the scope of this article). But we would suggest that this assumption is too simplistic, as many or even most investors should care about skewness (especially negative skewness) and kurtosis. If an asset exhibits non-normal distribution (as do many risky assets), mean variance analysis should only serve as an initial approximation of risk rather than a complete reflection of investors’ true preferences. If mean variance analysis underestimates risk, the result can be an overallocation to particular asset classes.(1)

Another problem with using standard deviation (volatility) as the sole measure of risk is that it fails to capture the fact that, as mentioned above, real investors tend to care much more about downside volatility and far less about volatility when returns are above average.

The Risk of Taking Risk

Another risk measure should be the probability of a negative outcome. This is especially true of investors who are strongly risk-averse, as they are more inclined to lose discipline and stray from a carefully constructed plan when the risk actually does show up.

This type of risk can be defined as the probability of failing to achieve one’s financial objective. Most investors’ objective is not to simply accumulate the greatest wealth, but rather to have sufficient wealth to achieve and sustain an acceptable lifestyle without running out of funds. With this objective in mind, the expected return of a portfolio should never be considered as a single point, but rather as a potential distribution of many possible outcomes. The use of a Monte Carlo simulator can help estimate the risks (odds) of failure, so that investors can judge the odds that they are comfortable accepting in seeking to achieve their objective.

Tracking Error Risk

Tracking error risk is purely psychological, though real nonetheless. For example, US investors who build globally diversified portfolios experience investment results that are quite different from those experienced by the “market,” which is typically defined by a broad major index such as the S&P 500. Some years, such as 2000-2003, investors may like the divergence, as the tracking error is positive (that is, their returns will be higher than “the market’s”). Other years, such as 1998- 1999, they may be unhappy with the divergence, as the tracking error is negative and their returns are lower than the benchmark against which they are comparing them. The risk is that negative tracking error can lead to loss of discipline, which can cause investors to buy or sell holdings at ill-advised times. Investors who are sensitive to tracking error risk should consider either minimizing it or avoiding it altogether by investing primarily or entirely in funds that more closely track common benchmarks.

The Risk of Abandoning the Plan

While overwhelming academic evidence indicates that the asset allocation decision is the most important determinant of returns, we would suggest that it is not the most important determinant of realized investment results. The most important determinant of realized results is instead the ability to adhere to whatever asset allocation is selected when the investment policy is designed. To illustrate this point, professors Terrance Odean and Brad Barber found that individual investors trading stocks significantly underperformed the market, and the more they traded, the worse they performed. (2)

Risk is Real

Another risk that should be carefully considered is that of a large negative surprise. Unfortunately, one of the most common and severe mistakes is to treat the highly unlikely as impossible and the highly likely as certain. Prudent investors know that, just because something has not yet occurred, does not mean that it cannot or will not occur in the future. One need look no further than the events of September 11, 2001 for proof of this important point. By learning about and accepting the real potential for significant negative surprises, investors are much better prepared to cope with them should they actually occur. Discussing this possibility ahead of time is a valuable service advisors can offer their clients.

The Risk of the Maverick

We are all familiar with the expression “misery loves company.” Experiencing relatively low (but still positive) investment results may create more psychological risks (and resulting abandonment of a prudent investment plan), than experiencing actual losses if everyone around is having a similar experience. As Robert Arnott points out:

“Practitioners “know” that the greatest peril is the risk of being wrong and alone. … This danger is sometimes called “maverick risk.” As such, we fall prey to the Keynesian dictum that it is more acceptable to fail conventionally than to succeed unconventionally. … Decisions that leave an investor alone carry the inherent risk of being both wrong and alone. If an investor is wrong and alone, a strong likelihood is that the assets’ owner will not have the patience to see the investment decision through. The decision, even if correct in the long run, will be reversed before it can succeed.”(3)

The Risk of a Short-Term Outlook

Another psychological risk is confusing strategy and outcome. Perhaps it is human nature to judge the correctness of a strategy only by its outcome. In reality, since we cannot predict the future, a strategy is either correct before the fact (before the future is known) or it is not. Consider the case of a family breadwinner with a spouse and children to support. Unless the family is independently wealthy, life insurance is almost always a part of a prudent financial plan. Yet we do not judge the correctness of this decision by whether or not the beneficiary collects on the policy. Purchasing insurance is a sound strategy, regardless of the actual outcome.

We believe that if the same perspective is taken on one’s investment strategy, it can assist in maintaining investment discipline over the long term. Nicholas Taleb describes it as follows:

“One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”(4)

The “Bearer of Bad Tidings” Risk

Finally, there is a risk that the investment advisor faces when telling clients or prospective clients information that they may not want to hear. For example, advisors who place the highest priority on clients’ interests must inform them that neither they nor anyone else know how to beat the market. Instead, the advisor can design a portfolio that will give investors a reasonable chance of achieving their financial goals given their current and desired lifestyle. A good advisor is one who delivers this message regardless of whether or not the investor wants to hear it.

While it may in the short run result in loss of business, in the long run this is not likely to prove to be the case. Further, managing client expectations in this manner helps ensure that those who do accept the news will be most likely to be successful, both for themselves and for the advisor assisting them. While standard deviation is one important measure of risk, as this paper demonstrates, it is certainly not the only one to consider when developing a financial plan and investment policy. The prudent investor considers all of the real and psychological risks of investing when developing his or her plan.

 

References:

1. Ulf Herold and Raimond Maurer, How Much Credit? The Journal of Fixed Income, March 2003.

2. Terrance Odean and Brad M. Barber, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Journal of Finance, April 2000.

3. Robert D. Arnott, What Risk Matters? A Call for Papers! Financial Analysts Journal, May/June 2003.

4. Nassim Nicholas Taleb, Fooled by Randomness. TEXERE, Copyright 2001.

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Larry Swedroe is the author of “What Wall Street Doesn’t Want You to Know,” “The Only Guide To A Winning Investment Strategy You Will Ever Need,” “Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today,” and “ The Successful Investor Today: 14 Simple Truths You Must Know When You Invest.” Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.