The Big Picture
“You can’t have your cake and eat it too!” -English Proverb
Your can either have it, or eat it, but not both! I have said this from time to time and many give a look of perturbation. “What do you mean I can’t have my cake and eat it too? If I have cake, I want to eat it!” Exactly. But after you eat the cake, you won’t have cake anymore. I don’t understand! This is infuriating…
The proverb acknowledges the recognition that usually you can’t have the “best of both worlds”. This is especially true with investing. There are trade-offs in investing. Such as the dynamic of risk and return, you cannot have one without the other. If you want more return you generally have to take more risk. How investors assess risk should be based on their planning considerations, suitability, and willingness to take risk. However, how we witness investors take risk is quite different. Behavioral factors tend to muddle the risk decisions employed. Which leads to the question. What is risk exactly?
Have a Plan and a Process!
From the Trenches
“Successful investing is about managing risk, not avoiding it” -Benjamin Graham
What is Risk?
Traditional finance defines risk as the difference between an investments actual return and its expected return. How risk is assessed is by determining the standard deviation (just think dispersion or spreading out) of returns over time. Historical data is commonly utilized to get an average or mean return. Then a comparison is made. That is it in a nutshell.
Is that the definition of risk the way most investors think about it? Not that I have seen. I can count on one hand those that have asked me about standard deviation over the years. Investors approach risk in a few different ways. Some examples:
1. What is the risk I won’t meet my financial goals?
2. What is the risk my neighbor’s portfolio will do better than mine this year?!
The first approach is how we would recommend you think about risk. The second can be quite perilous. Behavioral aspects are always present and at times drive investors mad. Regret, over-confidence, loss aversion, and one of the worst, envy. “My neighbor did better!” Usually when I have this discussion it mainly comes down to the level of risk taken which produced the results. Again, higher risk tends to lead to higher returns. Your neighbor likely took more risk. Period.
• Risk is a relative measurement.
• Higher risk generally leads to higher returns, over time.
• Behavioral aspects should be ignored when choosing risk to take. (Your plan is different than your neighbors!)
Bottom line: True risk is not meeting your financial goals, or permanently losing your capital. Risk taken can only be fully understood after the fact. Which is why risk management is critical.
“If you don’t invest in risk management, it doesn’t matter what business you are in, it’s a risky business!” – Gary Cohn
I had a client tell me once; “I need you to get me all the S&P (500) returns on the upside, and protect me from the downside!” I quickly realized he believed he could in fact “have his cake and eat it too!” Wouldn’t we all!
Back to Reality…
What is risk management?
Is it lowering standard deviation? Is it limiting volatility? Is it eliminating the potential for loss? That would likely eliminate most of the potential for gains as well. Risk management is having a process or strategy for limiting and managing identifiable risks through ongoing monitoring and analysis. Easy enough? Check.
Different strategies may employ different risk management methods. However some strategies employ no risk management at all!
This is important to understand. For example, the strategy of buy and hold, or passive investing; there is no risk management employed. Really! Are you sure? Yes, there is no risk management process. That is one of the key characteristics of passive investing. What does this mean? Allocations are selected primarily based on desired aggressiveness or other factors. Usually re-balanced over some frequency, and that’s it. What about diversification? While critical, diversification is not risk management. It does not limit or eliminate downside risk. Diversification reduces idiosyncratic risks, or the risks of a particular company or security. “All the eggs are not in the same basket”. Key word here is reduce, not eliminate. In fact, studies have shown diversification fails when needed most! (GBR) When a bear market begins, investors don’t care what they own, they just want out. “The baby goes out with the bathwater!”
The draw to employing a passive strategy is understandable. It is easy to comprehend, easy to implement, and supported by “perceived wisdom’s”. Ideally the way to go! The issue is the real world is not always ideal. I ran into a friend of mine and he asked me; “I just don’t understand why I wouldn’t just buy the S&P (500) and let it ride!” Furthermore stating; “In the long-run won’t everything be fine?” I hear this all the time. First, of course you may do that. That said, I have no idea what will happen over the course of time. Nor does anyone else. I have addressed some of these issues with time and the long term so no need to rehash it here. The simple truth is results from passive investing may be acceptable. But they also may not. There is much left to chance. Leaving your financial future to chance is not a strategy I would recommend.
What is critical is understanding the pros and cons of the strategy selected. All strategies have specific pros and cons.
Bottom Line: If you are interested in better understanding risk management, I look forward to the conversation. For those relying on expectations, theories, and beliefs; I wish you the best of luck. Unfortunately luck… is also not a risk management process.