How do you define risk? More importantly, what does risk mean to you and your investment portfolio? One of the most prevalent mistakes investors make in their portfolios is not properly defining and managing risk. This article is the first of a 5-part series on identifying and working to resolve some of the most common investment portfolio mistakes.
When it comes to defining and managing risk, factors such as your age, your need for financial support from your portfolio and the timing of those needs, and your investor behavior dictate the level, type and amount of risk you can (and should) assume. How you identify, budget for, and manage those risks, will be a big part of whether you ultimately achieve your objectives.
Risk vs. Volatility
Many people think risk and volatility are the same, however volatility can be a type of risk, rather than the all-encompassing definition of risk most assume it to be. Volatility is often used as a measure of risk because it is quantifiable and explainable. However, though volatility is always unpleasant, it is not always a risk. By definition, volatility is a temporary period of downward price movement; that is to say, if an investor can remain invested until prices recover, then there is no actual risk.
Volatility only becomes problematic when temporary conditions are made permanent by an investor selling during the drawdown in portfolio value. This selling can be brought on by an investor’s loss of confidence in their investment approach, which creates the feeling of a need to prevent further declines, or a need to access the capital. In the case of the latter, needing immediate access to the capital can be caused by an investment strategy that failed to accurately match the time horizons of the asset to the need, or failing to maintain proper liquid reserves. In any case, building a portfolio based on volatility tolerance alone often results in being overexposed to “real risk.”
What is Real Risk?
There are three distinct definitions of “real risk:” not having enough money, or access to that money, when it is needed; a permanent loss of capital occasioned by an investment gone wrong; and grossly overpaying for an asset.
1. Not having enough money, or access to that money, when it is needed.
For a person, maybe a retiree, actively drawing money out of their portfolio, volatility could pose a real risk, as they may be forced to sell assets during temporary downswings in order to meet cash demands. Alternatively, for a person with no need to draw money from their portfolio in the foreseeable future, risk takes on the form of not generating enough earnings to meet their long-term objectives. For this investor, designing a portfolio based on fear of volatility might overexpose them to real risks.
2. Grossly overpaying for an asset.
An overvalued investment can pose a real risk even if the asset eventually recovers its value, as the investor can never recover the missed opportunities. For example, someone who invested $50,000 in the NASDAQ index ETF (QQQ) on March 31, 2000 lost 80 percent of their money by September, 2002. While they didn’t suffer a permanent loss of capital, recovering their $50,000 investment by August 2014, there was an opportunity cost to holding the investment. Over that same period, the same investment in the S&P 500 would have earned $37,844 resulting in a balance of $87,844 on the same date.
3. Permanent loss of capital.
Permanent loss of capital can occur in a variety of situations but most notably when an investor invests in bond where the issuer defaults on their debt or in a company that goes bankrupt. Portfolio diversification helps mitigate this risk, as less capital would be at risk with any particular company or bond issuer.
Building a Portfolio that Contemplates and Manages Risk
While it is natural to be averse to risk, it is important to recognize that a risk-free portfolio is a return-free portfolio. Therefore, an investor must be willing to assume risk in the pursuit of return. Taking more risk, however; does not automatically result in more return. As Howard Marks, one of the greatest investment minds of our time, has pointed out on numerous occasions, “If more risk automatically resulted in more return, it wouldn’t be more risky.” As an investor, the decision you face is not whether you should or should not assume risk, but rather what kind of risk you will assume, how much of that risk you can tolerate, and is the compensation you expect to receive for the risk sufficient.
When it comes to managing risk, the most important thing to know is that the future cannot be accurately predicted. Even things that have gone a certain way ten out of the last ten times may fail to happen the same way the 11th time. The reality is, highly unlikely things take place every single day. Investors who recognize that you cannot predict the future build portfolios that consider a wider range of potential outcomes. Through prudent diversification tilted towards their need for income, growth or both, they are prepared to accept lower return if the most probable scenario occurs, opting instead for better performance if the scenarios they deem less likely to occur do, in fact, take place.
There is no on-off switch for risk—it is a fundamental factor in investing. However, by viewing risk in the right context, and properly defining and assessing it, we can help you manage the risks you assume based on your unique objectives, both short- and long-term. If you still have questions about risk, volatility and building a portfolio that efficiently manages these circumstances, we encourage you to reach out to our team of private wealth advisors. Also, be on the lookout for the next edition of this series to keep learning how to enhance your portfolio and protect yourself from these common mistakes.
Common Mistakes Investors Make in Their Portfolios:
- Are You Properly Defining and Managing Risk in Your Portfolio?
- Setting Realistic Objectives: How Overestimating Your Portfolio’s Return Potential Can Increase Your Risk and Hurt Your Chances For Success.
- Are You Letting Emotions and Overconfidence Alter Your Investment Strategy?
- Paying Too Much in Taxes? Two Ways to Manage Taxes in Your Portfolio
- Making Time Work for You in Your Investment Portfolio