III. Understanding Risk

Key take-aways

  1. The future is uncertain, and when the term risk is properly used in investing, it is simply another word for this uncertainty.
  2. I can think of five risks—five ways things may not work out as well as we expected—and each must be managed in a different way.
  3. One aspect of risk—variability in the market prices of your investments over time—tends to be over-emphasized. You in fact need to think about this risk, known as volatility, in relation to your time frame.

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In the previous section on compounding, I talked about expected returns.  Of course, actual results may differ from our expectations and almost always will—we may do better or we may do worse.  Expectation is inherently a view on the future, and the future is uncertain.

When the term risk is properly used in investing, it is simply another word for this uncertainty.  Doing better than expected and thus having more money is generally not considered a problem.  So, the risks we really care about are the downside risks—things don’t work out as well as we expected.

So, here’s a list of things, in the broadest sense, that could cause you not to reach any financial goal you set, despite having made a plan and kept at it:

  1. You suffer a change in circumstances that impacts your ability to save.
  2. Your return expectations are unrealistic, so you don’t save enough money to put to work to begin with.
  3. Your investment choices are in assets so “safe” they never stand much of a chance to grow your money sufficiently.
  4. One or more of your investments fails, resulting in a permanent loss of the money in that investment.
  5. The market prices of your investments move around after you buy them.

Let’s talk about each of these risks.

Randomness in Life

The first risk, and probably the most important risk, has nothing to do with investing per se.  It is bigger than that.  It is simply the uncertainty we all face in terms of how our lives unfold.  Our lives take unpredictable turns.  They are subject to random events.  We get a raise, or we lose a job.  We experience a costly illness, or our child gets a scholarship.  Stuff happens—good and bad—that, among other things, impacts our income and our expenses.  This in turn impacts our current savings and/or our ability to save in the future.  Here, the usual good advice applies—persevere, stay flexible, take the long view.

From a financial planning and investment perspective, we can recognize that certain life circumstances lend themselves to greater or less certainty.  For example, certain careers have greater job security and more steady income than others.  Predictable income streams from sources other than salary and investments, now and in retirement, also result in greater financial stability.  On the other hand, high debt loads increase vulnerability to adverse circumstances.  So, one thing we can do in financial planning is to take all this into account in thinking about appropriate risk to take on in our investment portfolios.  We discuss how you might do this in the section called Goals-Based Asset Allocation.

Return Expectations Too High, Savings Too Little

The second risk is of special concern today.  Many experts believe that rates of return on investments will be lower going forward than they’ve been in the past.(1)  None of us can know, but this may very well be the case.  In the previous section, I used 7.2% for the expected return for the S&P 500, which is what the return averaged over the decade ending on 12/31/2015, rather than the 9.5% it averaged from 12/31/1927 to 12/31/2015.  I personally think it is prudent to do so, as it reflects today’s level of interest rates.  My advice is simply to be cautious and use conservative expectations.  If you do so, and returns do in fact come in higher than expected, you will have scrimped more than necessary during your working lifetime, but will be able to live more lavishly in retirement.

Very Safe, Danger Certain

The third risk is often under-appreciated and arguably the most pernicious.  No one likes to see their accounts decline in value.  Cash stashed for safe keeping in between mattresses.And the last 20 years have been particularly traumatizing, with jarring declines in financial markets from 2000-2002 and again in 2008-2009.  In response, there is an urge to shun the whole thing and stick all your money in a savings account, the modern equivalent of stuffing cash under the mattress, given that you currently earn almost no return in a savings account.

This might feel comfortable in the here and now, but almost certainly dooms you from ever reaching your goal. The old car transports a heap of rubbish It is like inheriting a million dollars from an eccentric old aunt clear across the country on the condition you arrive there and claim it the following day.  But, because you are afraid to fly, you pack up and set out in your pick-up.

You’re simply not going to get there, and you never really gave yourself a chance.  If this is where you’re at, everything in this tab on Developing the Right Mindset is particularly important for you.  Just as someone could provide you with statistical perspectives on the risks of flying (including relative to driving) to help you make a more reasoned decision on mode of travel,(2) we hope to give you a statistical, analytical perspective on investing and its associated risks.  I also hope to make you more attuned to your emotions with respect to investing in Recognizing Your Emotions.

Investment Failures, Permanent Loss of Capital

Losing money in a particular investment is the most real, most basic investment risk.  How can you lose money in an investment?  There really are only two basic causes.  First, the cash flows from the investment decline from what they’ve been historically and what you expected them to be.  A government or company stops paying back a loan; a company’s profits persistently slide.  In the worst case, the government or the company fails altogether.  Second, less obviously, you simply overpay for the investment in the first place.  How can you best address these risks?

Fundamental investing: Benjamin Graham, often with his colleague David Dodd, pioneered the application of reason in investing.  He ran an investment firm and taught investments at Columbia University (Warren Buffett was both his student and employee).  As such, he was pragmatic.  Mr. Graham developed two fundamental ideas that are essential to managing this risk of what he called “permanent loss of capital”: (1) “intrinsic value” and a “margin of safety,” and (2) “inherent stability.” Under the Exercising Common Sense tab, in the section called A Sensible Approach, I discuss these ideas in some detail.  And I specifically explain how we apply these principles in the stock strategies we manage under the Stock Funds tab.  For you, the key is to select investment funds that adhere to these principles, as ours do.  This also entails skepticism about investments that are currently fashionable, as this popularity often results in the mistake of overpaying in the first place.

Diversification: All investments, even ones that rigorously adhere to sound fundamental principles, will have rough periods from time to time.  Again, the future is uncertain, and things impacting an investment can change for the worse, in ways that are unpredictable.  So, it is key to have many individual investments, which is known as diversification.  To achieve this within any single investment class, for example your stock fund(s), you will select funds that have invested in dozens of individual companies.  Given this portfolio of stocks, the overall fund return is not mortally wounded by a couple of companies that do poorly.  Rather, the portfolio does well over time based on the average return, on balance, across all the companies owned.  Second, you will likely diversify by holding more than one type of investment—for example, both stock and bond funds.  I will discuss diversification further under the Exercising Common Sense tab, in the section called Diversification without Complication.  And under the Invest tab, I show you how you might allocate among different types of assets in Model Portfolios.

Price Volatility, Erratic Price Behavior

The final risk—relating to price variability—is the one most emphasized in academic finance, especially in what is known as “modern portfolio theory.”  After you make an investment, the market price of that investment will most certainly move around—that is true of an individual stock or bond, or a portfolio of stocks or bonds.  This attribute of erratic market price movement for any investment is known as volatility.

Volatility can be measured (with statistical calculations like variance and standard deviation).  And the ability to treat volatility mathematically is the reason for its prominence as the measure for risk and often as the concept of risk itself in academic literature. I do not subscribe to this view.  First, volatility and volatility measures are not the be-all and end-all of risk.volatile market stock volatility down crash trend price investment index fluctuation vector  We need to think about risk more comprehensively, as outlined above.  Second, volatility is only a concern if you must sell into a price decline due to poor planning or if you sell out of panic.  Selling individual investments at a loss is sometimes the right thing to do, but doing so out of poor planning or panic is an avoidable mistake.

Again, the central purpose of this section on Time Frame and Mindset is to help you avoid such mistakes.  In truth, if an investment delivers on your expected return by the end of your time frame, how its price moved around in the interim ends up being irrelevant.  Volatility, truly as a risk, needs to be measured and considered according to your time frame.  This is the focus of the next section, Taking Advantage of Time Frame.

(1)Some of the reasons cited include: (1) higher starting prices for investment assets, which by definition lower future returns, due to (a) aging populations in the United States and other countries, resulting in more savers competing for investments, and (b) monetary policy around the globe pumping out money; and (2) slowing real economic growth in the United States and globally going forward.

(2)There is an interesting article, which you can find in the NOVA section of pbs.org, titled “How Risky is Flying?” by David Ropeik (10/17/06) on various statistical measures one could look at to put the risk of flying in perspective. The article makes the excellent point that you need to consider a number of measures to gain a complete perspective on the risks of this particular activity, flying. The same is true in investing. Rather than pick out a particular statistic to “prove” a point, it is critical to look at the full statistical picture to gain insight that is comprehensive and unbiased. This is why we favor, for example, averages over multiple years and the rolling average concept, rather than single point-to-point measures.