What is Investment Risk?

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

One of the go-to formulas of horror movies is to try to avert the audience’s (and character’s) attention away from the real risk. Someone hears a noise in a (supposedly) empty room, they walk in and see an open window. The unfortunate character starts focusing on why the window would be open, maybe even leans out the window and starts looking around. At some point, the character is satisfied that the open window is no longer a threat (whew!), closes the window, turns around, and BAM! You find out the real risk came in through the window and was hiding in the room. Now, the settings and characters change (why don’t we try having a group of sharks caught in a tornado?), but the formula remains the same.

Similarly, investors can sometimes get caught focusing on certain risks, while it’s often the ones they’re not focused in on that cost them the most.

One of the most widely used ways that investors look at risk is the standard deviation of an investment. Harry Markowitz won the Nobel Prize largely on his work on Modern Portfolio Theory (MPT), which defines risk as standard deviation. The standard deviation gives you a basic measure of how volatile the return stream of an investment has been (or is expected to be), and is extremely useful in getting an understanding of what to expect in a normal environment.

11.22.13_Raupp_Whatisinvestmentrisk_2MPT took the concept of risk further in recognizing that the correlation of investments in a portfolio is also important, that the combination of investments with a low or negative correlation to one another can create an outcome where you can get a higher level of return for a given level of volatility. This enabled investors to create an “optimized portfolio,” which was the best possible mix of investments to maximize your return for a given level of risk.

The problem with this is that we don’t live in a normalized world, where return distributions are symmetrical and correlations between investments remain constant. 2007 and 2008 were shining examples of that. Quantitative strategies that had been effective in a “normal” environment collapsed when price moves that they had viewed as “once in a million year events” started occurring with regularity. Optimize all you want, but if you owned an investment vehicle backed by Lehman Brothers you probably didn’t have a good outcome, even if you were on the right side of the trade.  And not many people factored in the possibility of their money market fund breaking the buck, as happened to the Reserve Fund.

So, what’s the solution? Diversification. Inevitably you’ll find your investments adversely affected by some kind of risk; however, with proper diversification just part of your portfolio will be affected rather than the entire thing. But while the MPT concept of diversification starts you in the right direction, it doesn’t check all the nooks and crannies where danger might be lurking.

Thinking about how asset classes would react under different scenarios or events helps you to better protect your portfolio. Entering 2007 most investors would have thought commodities were good hedges against a stock market decline. Commodities had done very well in 2000-2002 when the tech bubble burst, and touted a negative correlation to stocks over most trailing periods, a huge consideration when optimizing a portfolio using MPT. But when a deep recession caused consumption and production to plummet, commodity prices dropped right along with stocks, leaving many investors scratching their heads. The credit crisis did that to nearly all asset classes with any level of risk associated with it, leaving the only winners investors in high quality bonds and a relatively obscure (at the time) strategy called managed futures.

11.22.13_Raupp_Whatisinvestmentrisk_1The lesson is clear. There are times when “normal” becomes abnormal and the way asset classes interact with one another changes. So while checking the open window in the empty room might be the right thing to do 99% of the time, it pays to be on the look-out for the monster in the closet.

Seeking a Greater Purpose in Investing

Dan WilliamsDan Williams, CFP, Investment Analyst

The “science” of investing is well known. The modern portfolio theory (MPT) of investments developed over the past 50 years, starting with Harry Markowitz, has become so ingrained into the investment management culture that the concept of portfolio diversification has become second nature to most people. This is of course due to the mathematical analysis showing that diversification improves investment portfolios’ risk and return characteristics. To say differently, it makes good math sense.

6.27.13_Williams_1Recently though, investment management research has begun to venture into the new field know as Behavioral Finance. At a high level, this theory points out that the owners of these investment portfolios are not emotionless robots that are attempting to optimize the expected value of portfolios for a given level of risk, but rather humans who have reactions to watching their portfolios change in value and who also have goals for the wealth created. Often times this theory’s task seems to be to point out our human flaws and biases so that we can move closer to MPT. This includes our confirmation bias (seeking out only information we agree with rather than information that challenges our thinking), overconfidence bias (believing we are above average in our skills), and loss aversion (finding that we will irrationally gamble to avoid a loss already sustained but unwilling to take a gamble that might result in a loss, even when the odds are in our favor). Still, this idea also points out what gets lost in the math of MPT. Specifically, that an investment portfolio has greater purpose than just the accumulation of money.

The meaning here can be shown in the following dream scenario. You take a trip to Vegas, you see a slot machine, you put a dollar into the machine for fun, pull the lever, and you hit the big jackpot. You are then told that you can either have the $10 million prize immediately, or a flip of a coin for the chance to win $25 million or lose it all. The vast majority of people would take the $10 million dollars. Consider instead the experience of the MPT optimizing robot. First, the robot would likely not put the $1 into the slot machine. Why put $1 in when the expected value is $0.95? Second, given the jackpot options the robot would likely gamble it all at the chance for $25 million as the expected value of $12.5 million is greater than the $10 million. The math is clear—the robot is optimizing and we are not. But that is not the whole story.

6.27.13_Williams_2First, most humans get utility from putting a dollar into a slot machine outside of the outcome of the gamble. As such, we may be rational to gamble if the utility of the $0.95 expected value and the experience of gambling together are greater than the utility of the $1 in our pocket. Second, given the jackpot options, outside of the fear of losing the $10 million, there is also a diminishing marginal utility to money. That is to say simply that an extra $1 million to you or me changes our lives a lot more than an extra $1 million to Warren Buffett. It is quite possible that the utility we tie to that first $10 million is greater than the utility to that next $15 million. As such, we could be rational in both the action to gamble and the decision to take $10 million.

While lottery dreams are nice, the practical meaning is that our investments allow us to do things. Said differently, our investment balance is not just a number, it represents our ability to meet goals. To some, that $10 million meant the ability to have the freedom to travel, to retire for others, a fleet of cars to those so inclined, and a chance to make the world a better place for still others.

NorthstarIn this line of thinking, the relatively newly developed bucket approach to investment management ties specific assets to specific goals. This simple concept turns a portfolio that is invested based on some risk profile that in an opaque manner will meet your goals into a portfolio of portfolios that represent directly your goals. Accordingly, rather than having portfolio performance measured against a generic market benchmark, the measure that matters is whether each of these portfolios is on track to meet their assigned goals. Accordingly, Brinker Capital’s recent offering in this area is appropriately named “Personal Benchmark.” A final point is that people draw utility not just from spending their investments to meet goals, but also from where and how they invest. Socially Responsible Investing, also known as ESG (Environmental, Social and Governance), allows people to allocate capital where they believe the welfare of those outside themselves is best considered. Outside of the fact that there is evidence that investing in industries and companies that have these positive attributes may also improve investment performance, the fact that we are able to encourage positive change in the world while we save for our goals is a powerful concept.

In aggregate, the recent changes to investment management are brilliant in their simplicity to give purpose back to investments. The more empowered we feel with meeting our goals with our investments, the more likely we are to meet, and even exceed, those goals.