December 2005
The concept of investment risk has been so utterly mangled by our industry that even most professionals have forgotten what it really means. Basically, they've settled on the idea is that risk equals volatility. Measuring volatility is pretty easy to calculate, a little more difficult to understand and it's nearly impossible to predict how an investor should react to it. That's the problem. We need a better way to think about risk when it comes to investing.
The two most often cited statistics used to measure risk are "standard deviation" and "beta". So, right off the bat our industry has defined risk in such a way as to make most people feel completely lost!
Let me briefly explain what each of these conventional measures of risk mean in (hopefully) straight-forward language. However, before you completely waste your time trying to understand them, let me tell you they are not really worth understanding in the first place! Having said that, we might as well dig in, right?
Standard deviation is a way of calculating the expected variation of a set of data around its average number. Get it? Maybe if I put it another way it would makes a bit more sense. For example, when a mutual fund or an investment manager says their standard deviation was 20% and the average return over a period of 5 years was 10%, they're essentially telling you that most of the time (actually about 70% of the time) you experienced an annual return between -10% and +30%. As you can see, it is a fancy way describing how bouncy the trip was to get that 10% return. Now, let's move on to the second popular risk measure, "beta". Being a half Greek-American with a degree in math, this is pretty exciting stuff!
Beta is only a little bit different than standard deviation. Where standard deviation was measuring the amount of bouncing you went through to get a certain return, beta is measuring an investment portfolio's tendency to bounce along with the market (depending on what we consider the "market" to be, of course). In other words, it's a way of describing how closely an investment portfolio moves in tandem with say, a basket of hundreds of stocks in the S&P 500 or even one with thousands of different stocks, like in the Wilshire 5000. If its beta is 1, then when the "market" moves up or down, the portfolio itself moves up and down in lock step. If the beta reads less than 1, the investment tends to move less in tandem with the market. As you probably could guess, a beta reading of greater than 1 implies that its bounces were even more amplified than the market.
And so, with these two high-powered stats in hand - beta and standard deviation - the entire investment industry has successfully built an elaborate way of measuring risk. You'll probably see them the next time you look into a mutual fund or stock. The only problem is that these stats don't mean much to the very people who are risking the money, you and me and millions of other investors!
Does it really matter if your portfolio bounces around more if after 10 years you've made a better return than one that barely moved around at all? Which investment was really riskier? And have the gods of finance decreed from on high that historical bounciness has anything to do with an investment's future propensity to bounce? For that matter, are all types of bounciness even considered bad? For example, I can confidently presume that most of us don't mind upward bounces all that much. What I'm pointing out is that the question of risk isn't easily answered by doing a bunch of historical statistical handiwork. It turns out that risk really is in the eye of the beholder. In fact, it probably depends a lot on how much extra money you in fact behold! If using these statistics leaves us wanting for a definition of investment risk that does matter, then here is one that just might work.
"Risk is losing money over a longer stretch of time than you can comfortably tolerate."
What does comfortable mean? It means you're both financially and emotionally able to handle it all. It's important to stress the word, "both", here. For example, we all know people who are crazy enough to risk everything they have for a shot at glory. They just might not be that capable of recognizing risk. On the flip side, a person might be financially able to roll the dice, lose it all and still not worry about their basic needs or even this year's vacation plans. Yet, if they're actually losing sleep when their portfolio is down 10%, it is obvious they just can't stomach that much risk. So, how should we use this not-very-statistical definition of investment risk? Here's a very basic and admittedly simplistic suggestion.
First, you should figure out how much money you need to live off of during a normal year in retirement. Second, from this number, subtract out any other source of income that you can bank on, such as Social Security or other pensions. Next, depending on how much money you hope to leave behind, multiply your resulting number by either 20 (you aren't planning to leave much) or 30 (you'd like to leave the whole pot). This dollar amount is a pretty good estimate of the portion of your nest egg that you shouldn't risk much. Honestly, it should mostly (probably no less than 60% and no more than 90%) be invested in income generating assets that you can count on and live on. Call this portion your "living wealth".
For any amounts that you've accumulated above your living wealth, our definition of risk comes into play and actually can work to your advantage. If you know the right kind of investments to look for and you have the requisite patience to ride out stretches of meaningless bouncing, then you can expect to make a better than reasonable return on your money.
If you have time on your side, then why should you care about the standard deviation of your returns or the beta of your portfolio? If you can comfortably tolerate watching your portfolio change in value daily, then why should you care so much about the market's ever changing opinion about its value? This leaves you with the time to focus on the only important question to ask when it comes to investing, "Is my portfolio worth more than the market thinks it is?"
Now, knowing the right kind of investments to look for still remains the biggest challenge. Despite what you may have heard, you can't just crank up the risk, shut your eyes, set a timer and then expect a magical result. However, by having settled on a workable definition of risk it's safe to say you're already miles ahead of most investors out there. And yes, that includes even most professionals in our industry.
Jason P. Tank, CFA
jason@frontstreet.com