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Chapter 2: Assessing the Risk

By: Investor Solutions

“Risk” is the investor’s four-letter word. Everybody is risk-averse. We all would prefer a certain, or riskless, result. It’s rational and normal to be concerned about investment risk. But at some point, normal concern becomes irrational fear. And that exaggerated fear keeps too many people from making appropriate investment choices.

Investment risk can be an extraordinary stress for many. I have seen investors throw up when the value of their portfolio dropped by 5%. Others worry themselves sick slowly, over a long period of time. In a society that judges happiness, security, power and prestige by the number of zeros in a bank account, perhaps that shouldn’t surprise us. Money takes on a sacred aura, and a threat to wealth, even temporary, seems life-threatening.

Risk aversion is not a matter of personal courage or “manliness.” I know hundreds of combat-tested fighter pilots, infantry officers, and tank commanders who cannot make themselves leave their comfortable, “safe” CDs. I believe in many cases, risk aversion is a fear of the unknown, a feeling of being out of control, or of not knowing how bad things might get. Without solid information on the “threat,” risk becomes a Bogey Man 12 feet tall!

The conventional wisdom – that the stock market is somehow treacherous and dangerous – certainly contributes to the problem. As we have seen, the conventional wisdom is often wrong. In fact, stocks have been a highly reliable engine of wealth for long-term investors. In this chapter, we will demonstrate that market risk is almost exclusively a short-term phenomenon which falls over time, and that not being part of the market may be one of the biggest risks of all.

Even investors who are comfortable with risk will benefit from a better understanding of what it is, where it comes from, how it is measured, and how it can be managed. Later we will use this information to construct “efficient” portfolios to meet your individual needs. “Efficient” means that either we will obtain the maximum amount of return for any level of risk we choose to bear, or meet our rate of return objective with the least amount of risk.

A World Without Risk

Just for a second let’s try to imagine an investment world where there was only one dimension: rate of return. Investment choices might look like this:

Investment Returns

 

All returns are certain. Investors would, of course, decide that more is better. Everyone would want investment A. No one would consider investment B. Investment B would cease to exist as a choice for lack of takers. Everyone would get the same investment result, and no one could aspire to a higher rate of return.

Risk Offers the Chance for Higher Returns

Now let’s imagine a second dimension. Investment choices might look like this.

Investment Returns

Investment B offers a known outcome. Investment A introduces an amount of uncertainty. The results are variable.

The Investor’s Dilemma

True choice now exists. Investors face a dilemma. They prefer a certain result. However, they also want the higher returns offered by investment A. They are trapped between wanting a certain result, and wanting more. Some investors will opt for the known result, and some will decide to go for the higher rate of return.

Risk is, of course, the primary concern of investors. Acceptance of risk is what separates our “savings” from “investments.” The successful investor must come to terms with the implications of accepting risk. He knows he cannot have it both ways. He cannot hope for higher returns without accepting the fluctuation. And he must realize that all fluctuations are not positive. Not every day will be uniformly wonderful. He must be honest with himself about his tolerance for risk, and resist the temptation to second-guess himself when the inevitable bad day arrives. Bad days are built right into the investment strategy. As we shall see, there should be many more good days than bad, and we will make more during the good days than we will lose during the bad. But it makes no sense to pretend that the bad days aren’t going to come.

Investors who pretend that they are somehow exempt from risk set themselves up for disaster. One of the very worst things an investor can do is accept a risk with the expectation that his investments will only go straight up. Markets do not work that way. And an investor who doesn’t understand that will fall prey to the buy-high, sell-low, vicious downward spiral syndrome.

The time to fully understand your risk tolerance and the risks in your investment portfolio is before you make your investments!

In economic theory, at least, we all have many different combinations of risk and reward that we would find equally attractive. If we were to plot all those combinations, the resulting line would be called our indifference curve. We will have to examine the concept of indifference curves once more in relation to Modern Portfolio Theory. Since I have never found a real, live investor who has plotted his indifference curve, we won’t spend too much time on it. I must confess that I have no idea what mine would look like.

The amount of additional return which must be offered to an investor in order to pry him away from his known result is called the “risk premium.” The speculation that investors often change their risk premiums as a result of recent events goes a long way toward explaining market excesses and the lemming-like behavior of investors.

The Professional’s View

Stock market returns can be described as random distributions with a strong upward bias. Over a long period of time, returns in a market or a particular part of a market remain fairly constant. Periods of over- and under-trend performance are often followed by a regression to the mean.

Distributions around the average line fall in a rather predictable bell-shaped curve. Investment managers describe investment risk as deviation around the expected rate of return. They measure it with standard deviations. One standard deviation will contain about 68% of the expected future returns. A small standard deviation will indicate a closer grouping around the average, and less risk.

Bell Shaped Curve

 

 

Since most of us don’t think about standard deviations very much, this may be a more visual and intuitive way to look at it. The S&P 500 has an average rate of return of about 10%.

Risk Concept

 

 

The standard deviation of the S & P 500 is about 20%. So about 68% of the time, results should fall between -10% and +30%. We might call a return falling inside this range an average result.

Risk Concept

 

But about 32% of the time, returns will fall outside of the range.

Risk Concept

 

A result may fall outside of one standard deviation, but within two standard deviations (-30 to +50%). We might say that these are unusual returns. Returns will stay within two standard deviations about 95% of the time, or 19 out of 20 years.

Returns may even get outside of the two-standard-deviation range. The three-standard-deviation range is from -50 to +70%. Results will fall within three standard deviations 99.5% of the time, or 199 out of 200 years. In layman’s terms, we might describe a result over two standard deviations as very weird.

The smaller the variation around the expected result, the smaller the standard deviation, and the smaller the risk. It’s important to understand that risk doesn’t necessarily mean loss. All investments vary a little from year to year, even savings accounts, so they have a measurable risk. But in the case of savings accounts, we would never expect to have a loss.

Other markets will have different rates of return and different standard deviations.

Sources of Risk

Risk comes from several sources. Most finance books break it down like this:

 

  • Business Risk – A company may fail, leaving the stock or bond you hold worthless.
  • Market Risk – Even if you have a strong company, a declining market may carry your stock down with it.
  • Interest Rate Risk – The value of bonds varies inversely with interest rates. Stocks and other property are also affected by general interest rates.
  • Inflation Risk – Your investment may not keep pace with inflation, resulting in a decrease in wealth or buying power.
  • Currency Risk – Foreign holdings may change in value as the value of currency changes.
  • Political Risk – The government may do something to harm the economic climate. This can vary from raising taxes, revolution, war, or confiscation of property, to imposing a minimum wage.

After 22 years of counseling investors, I am convinced that the classic textbooks have overlooked one of the biggest risks of all: Investor Behavior. While there are exceptions, economists are constantly amazed at the ability of individual investors to obtain such poor results. In an efficient market, individuals should not be able to do as poorly as they do. An entire branch of economics has devoted itself to trying to explain investor behavior, and how it affects their results and the markets. We will have lots more to say about that later.

Another risk that we don’t find in the traditional finance books is the very real risk that an investment management decision in either market timing or individual security selection may be wrong. Active investment management always adds additional cost, may not produce an additional return sufficient to cover the cost, and may introduce additional risk into the portfolio. The debate over active vs. passive investment style is one of the hottest in finance.

Risk is Part of the Investment Process

Risk is never going away. It is part of life, and part of the investment process. Any investor that thinks he has banished risk is just fooling himself. He has traded one risk he understands for another he doesn’t. Or sometimes investors simply choose to ignore some risks. In particular, investors often underestimate or ignore the devastation that inflation can cause on a fixed income. Inflation is like a slow-growing cancer. At first you may not notice it, but eventually it will kill you.

Each risk can be mitigated and managed using well-defined techniques. The trick is to manage your portfolio to achieve the maximum level of return at any level of risk you are willing to accept, achieve your goals with the least risk possible, and develop a strategy that has the highest possible probability of success.

Most investors are risk-averse. If they want an adrenaline rush, they will take up skydiving! You can take lots more risk than what we advocate here. But our discussion is intended for the vast majority of Americans looking for a sensible college fund, retirement plan, or general wealth accumulation strategy. We will confine ourselves to the traditional liquid markets, and avoid more risky speculations.

Factors that Multiply Risk

  • Concentration of Investments – An investor who held only Pan American, Eastern Airlines, or IBM has suffered for violation of the fundamental investment principle of diversification.
  • Leverage or Margin – We have seen how leverage magnifies risk.
  • Options, Futures, or Commodities – Speculation in all these markets utilize extraordinary amounts of leverage and carry the appropriate amount of risk. Most speculators are rather quickly wiped out. Ironically, these markets exist to allow business or investors to hedge risk and insure themselves against an adverse market move. Used in this manner, hedgers can usually accomplish their goal at a nominal cost.

An Investor’s View of Risk

Fluctuation is Not Loss of Principal

In the real world, investors define risk in a variety of ways. Mention risk, and many will begin to imagine total, irrevocable, gone-forever loss of their principal.

Fluctuation is not loss of principal. It is just fluctuation. Here’s an example that should make the difference clear. Let’s say you believe that your backyard must contain oil. After a million dollars of drilling expense, it turns out that there is no oil. No matter what you do, no matter how long you look at the well, no matter what happens to the price of oil, your money is gone. You have had an irrevocable loss of capital.

Let’s say that you took the same million and bought a diversified stock market portfolio. You then have an unusually bad result the first year, and lose 20%. Well, you have had an interesting fluctuation, but have not had a capital loss if you can refrain from doing the very worst possible thing and selling while the market is down. And markets have always recovered in the past. Past history would indicate that all you must do to recover and go on to acceptable profits is to hang tight. While an individual stock can certainly go to zero value, entire markets don’t. Except for war or revolution, I am unaware of any market that has gone down without recovering. As long as we expect the value of the world’s economy to continue to grow, the value of the securities markets will reflect that growth. Equity investors will profit and be rewarded handsomely for enduring the aggravation that risk entails.

Visualizing Risk

Standard deviations may be a very precise and technically correct way to describe risk, but I don’t find it very intuitive. If we look at the pattern of returns in individual markets, we can perhaps get a much more visual and intuitive feeling for risk and reward.

Treasury Bills have low returns and little risk. As you already know, T-Bills have never had a loss, but don’t earn enough to provide meaningful real returns.

Annual Returns 1926-1993

 

Long-term Treasury Bonds have displayed a surprising amount of volatility as interest rates change. Many investors with “safe” government bonds or high-grade corporate have been shocked to see how much their capital account varies as interest rate changes.

Annual Returns 1926-1993

 

Commercial bonds show some increased risk, but still have disappointing returns.

Annual Returns 1926-1993

 

Turning to stocks, the S&P 500 shows an increased amount of risk, but has generated meaningful real returns.

Annual Returns 1926-1993

 

Small company stocks have even higher returns, but also the highest amount of variation. Not everybody wants to endure this much fluctuation in their accounts. As you can see, it can be a wild ride.

Annual Returns 1926-1993

 

By looking at the previous series of graphs, the relationship between annual (short-term) rates of return and risk becomes pretty clear.

Market Risk is Short-Term Risk

But short-term results aren’t the whole story. If that’s all you focus on, you will miss the boat. Successful investors know market risk is a short-term risk that dramatically decreases over time. The longer we hold a risky asset, the more risk decreases. Let’s look at the S&P 500, for instance. The longer we hold the asset, the lower chance of loss. There has never been a loss during any single 15-year period since 1926.

Risk Falls over Time

Look how the pattern of returns changes as we go from 1- to 5-, 10-, 15- and 20-year holding periods. You can see that there is much less variation during longer holding periods. While the chance of loss is reasonably high (30%) in any one year, it falls rapidly. Even during the Depression and in the 1970s, there has never been a loss while holding the S&P 500 for 15 years or longer.

Risk Decreases With Time

Risk Decreases With Time

Risk Decreases With Time

Risk Decreases With Time

Risk Decreases With Time

 

So market risk decreases with time.

How Often Can You Expect Losses?

Here is another way to look at risk. In any one-year period, there is a 30% chance that you may not make money. An optimist like me would say that there is a 70% chance of gain. Now, I will deny till my dying breath that stock market investing in any way resembles gambling. But if it were gambling, the odds would be stacked heavily in your favor. A race track couldn’t last an afternoon with odds like that! And look how quickly the odds improve as time passes.

Risk Decreases With Time

How Bad/Good Can It Get?

Investors may be concerned with a worst-case analysis. They often think: “What’s the worst thing that can happen to me?” As we have seen, in a one-year period or shorter, results can vary dramatically. Over time, a different pattern emerges. Here is a best-case, worst-case, and average-result analysis for the markets we have looked at for all 20-year periods in the last 60 years. Notice that the worst-case result for equities almost equals the best-case results for T-Bills (a good proxy for most savings instruments), and the average result for equities exceeds the best case for any debt instrument.

Best/Worst/Average Returns

How Often Will You Beat Inflation?

Some investors may view risk as the chance of not beating inflation, the failure to obtain real rates of return, or losing buying power. Here again, stocks perform very well for long-term investors. The chance of beating inflation starts out better with stocks and rises to certainty at 20 years. No one who held the S&P 500 for any 20-year period since 1926 has ever failed to beat inflation. The chance of beating inflation with bonds is lower than with stocks in early years, and falls sharply over time.

Chance of Beating Inflation

The Risk-Reward Line

So each of the asset classes we have examined has both a rate of return and a risk associated with it.

Risk Reward

 

And if we plot the risk against the reward, we come up with the risk-reward line we all know intuitively exists.

Risk/Return Statistics 1926-1993

 

The markets are far too efficient to allow higher rates of return without increased levels of risk. As they are so fond of saying at the University of Chicago, “There ain’t no such thing as a free lunch” (a.k.a. TANSTAAFL). An investment proposal in violation of the “free lunch” rule is an early-warning indication of a con job. Investment results far from the risk reward line are just not going to happen. There is never a high return without high risk. If investors would keep that rule in mind, most of the boiler-room operations would be out of business overnight, and many of the horror stories we have heard would never have happened.

Risky Business

As we have seen, there are several ways investors may view risk. Investors might want to consider if the real risk they face is the failure to meet their goals. If so, they will want to construct portfolios which have the highest probability of meeting their goals. The paradox they must deal with is that what appears risky in the short term turns out to be very conservative in the long view. The longer your time horizon, the more certain you are that stocks will outperform alternatives. Given the higher rates of returns associated with stocks and the high probability of attaining those superior returns, what long-term investor in his right mind would want to be protected against that?

An appreciation of risk will make you a better investor. Hopefully we have cast some light on the dimension of risk. Risk is real, and it is built right into the investment process. But it may not be as great as many Americans think. It’s not a Bogey Man 12 feet tall. And risk shouldn’t prevent you from making rational investment choices. Still, it’s the central problem in investment management.

Most of you have probably realized by now that with risk in equities so closely related to holding period, time must be a very important dimension of the investment problem. We will need to pay close attention to time horizon as we design portfolios to meet your specific needs.

No one can eliminate investment risk, but there are effective techniques to manage and mitigate each type of risk. We will deal with the classic risk-management techniques in the next chapter, which will be online April 11. Later we will explore Modern Portfolio Theory, a great advancement in reducing risk by properly balancing and structuring your holdings.