Risk In Perspective
By Mark Wendell
As safe as houses is an old expression that has new irony for those of us who weathered the Great Recession, when the home mortgage market proved to be built on sand rather than rock, and many homeowners found themselves in foreclosure. As safe as a bank vault is another expression that doesn’t mean the same today, looking back at the banking system’s collapse. As Warren Buffett explains what happened, “To make money they didn’t have and didn’t need, they risked what they did have and did need.”
Banks and insurance companies failed at their basic job of evaluating risk, deluding each other into a be
lief there was no such thing as failure, not for them. Instead of realizing how much was really at risk, they trusted triple-A ratings that proved to be illusions, and bank securities that were anything but.
We’ve been left wondering if there’s such a thing as a no-risk investment. Apart from investing in the education of a child — where the upside is infinite and return can be enjoyed daily, long before maturity — it’s hard to point to one.
There’s value in the capacity to tolerate risk, a quantifiable figure in many situations. Investors expect to be compensated for taking-on a burden of risk. The greater the amount of risk an investor is willing to take, the greater the return expected. For example, a bond issued by corporation offers a return higher than the going rate of a U.S. Treasury bond simply because a corporation is much more likely to go bankrupt than a nation of 300 million people that has prospered for centuries. The same direct-proportion relationship applies to equity investments or stocks: Generally speaking, investing in a well established, dividend-paying enterprise has a lower risk of dramatic loss than does pushing chips into the ante of an unproven start-up’s IPO, but also a fainter possibility of skyrocketing returns.
Risk is, essentially, a subjective psychological phenomenon and an almost sensory experience, the perception of one’s personal fears processed through our future-gazing frontal lobes into scary “what if” scenes.
Investment advisors evaluating the needs of a new client often ask a series of sophisticated questions that serve the same purpose as the pain chart in a doctor’s office, where a smiley face gradually loses its smile — the basic question is, “On a scale of one to ten, how much pain do you feel at the thought of losing everything?” What the advisor needs to know is whether the client can sit in only mild discomfort while watching a portfolio depreciate, or if he’ll be hopping around the room in agony — once that’s determined, a good financial advisor should be able to prescribe investments that are both effective and well tolerated.
Investopedia describes an investment manager’s responsibility: “Developing a proper asset allocation in a portfolio requires balancing many factors including risk tolerance, cash flow needs, time horizon and return requirements.” Investment advisors have refined dependable methods for coping with the multi-dimensional, fluid nature of risk. Apart from buy low, sell high they include:
Diversify broadly — Choose assets based not just on their own volatility and expected return, but also those of other asset groups in the same portfolio. Combine a variety of investment groups or classes reflecting a range of strategies and management styles.
Rebalance periodically — As one part of a portfolio appreciates strongly and other portions perform less effectively, move funds around to take advantage of gains and head-off losses, with the object of bringing the portfolio back into the original intended range of risk-versus-reward measurements.
Monitor closely, but sit tight — Markets gyrate dynamically, a fact no investor should shrug off by leaving assets in the dark to grow unseen like mushrooms. Stay up to date with tides, forecasts, and warnings… On the other hand, keep a steady hand on the tiller. There’s a common tendency to get lulled into a false sense of security during booming markets, and then swing to excessive caution when values drop, leading us to invest more aggressively in up markets than in down markets. Raging bull markets are likely to have huge hidden risks, however, and staying true to a strategy tailored to personal tolerance for risk can yield acceptable returns even during hair-on-fire bear-market scares.
Make adjustments as results and changing personal objectives warrant — Bear in mind a person’s comfort level with risk is also dynamic; generally, we tolerate risk during our years of building investments but want to minimize risk as we approach a time when we may need to draw on the assets we’ve built.
There’s no substitute for the client’s personal involvement, acceptance of responsibility, and attention to planning in the financial advisor’s task of fine-tuning the balance between risk and return. It would be nice to have scientifically accurate numbers to go by, but since risk is a highly personal and subjective experience, the best guidance an investor can give his advisor comes from honest self assessment: How do we perceive risk? How have we reacted to actual risk experiences in the past? Evaluating risk really means evaluating what we care about in life — and there is no simple formula for that.