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How should affluent investors understand and deal with risk?

By David Norton - April 12, 2022

Investing can be defined as forgoing consumption today to increase one’s ability to consume tomorrow.

Delayed gratification…

Making decisions about the future, even though we can’t possibly predict it.

It boils down to the conscious acceptance of risk in pursuit of return.

Following on from last week’s blog on asset allocation and risk for high-net-worth individuals

Most people think about investing primarily in terms of the return they might make.

But there are two important elements: return and risk.

In other words, the money made, and the risk tolerated to make it.

It’s easy to make money in the stock market, especially in the good years…

And data tells us that most years are good.

After 15 years as a financial planner, I’m convinced that risk is the more important, and problematic part of investing.

Risk, not return, is what distinguishes the most successful investors I see.

To determine whether an investor did a ‘good job’, we must look at something called “risk-adjusted return”.

This considers both the return that was achieved and the risk that was taken in the process.

How do you measure risk?

The problem is, of course, how to measure and determine the risk taken.

(Whereas return is easily measured).

In the 1960s, finance academics and theoreticians chose volatility as the measure of risk.

Probably because volatility (how much asset prices or returns fluctuate over time) is easy to quantify.

This is a great advantage for using volatility as the measure.

The problem is that, in my opinion, volatility is not the real risk (even though historic volatility can be measured).

If we consider risk as the probability of future loss, this is also something that can’t be quantified.

Even after the fact.

For instance, if you buy something for £100 and sell it for £200, was it risky or not?

How much risk was there at the time the investment was made?

Where do you look to find that number?

Was it a risky asset that produced a lucky gain, or a smart (and safe) investment that was sure to produce a profit? You can’t tell.

The formulas that calculate risk-adjusted return using volatility as the measure of risk are easy to apply but, in my mind, not appropriate.

As I mentioned in my last blog, I would argue that risk, in the context of individuals or families, should not be measured in terms of volatility of return, but in relation to the degree of urgency associated with reaching (or not reaching) the goal.

Or in other words, the probability of losing money.

It should be noted that there are many forms of risk, which should be considered to some degree. For example, with an investment that ultimately proves to be profitable, an interim price decline or changing world events (such as a pandemic or a war) might cause an investor to sell at a low and miss out on the subsequent rebound.

This is a form of risk and one faced particularly by those who choose DIY investing.

How do DIY investors perform?

DIY investors… underperform.

That’s a fact.

One poor decision can decimate an investment portfolio.

Take the S&P 500. Countless studies of investor behaviour show that the average DIY investor underperformed this index by 4.2% per year for the last 20 years.

My experience is that international investors do a lot worse.

Emotions like fear and greed drive DIY investor behaviour. It’s also hard to remain motivated.

Then there is the question of knowledge – how much does a DIY investor know about costs and taxes?

Or the difference between accumulation and distribution share classes?

Rebalancing and diversifying?

Finally, time is not on the side of the DIY investor. Most will have a career or plenty to keep them busy when retired (family, friends, hobbies etc.).

For financial planners, looking after your money is a passion and a full-time job.

This is why our clients don’t underperform the market or waste money on commissions and taxes, but rather remain balanced, diversified and in the market for the long term.

What a fiduciary financial planner will save you in taxes and excessive fees will more than cover their annual fee.

You will be guided by them and your own personal financial plan.

But I think the possibility of permanent loss (and therefore not reaching a goal) is the one that matters most.

What is risk?

Peter Bernstein wrote risk arises from uncertainty.

“There’s a range of outcomes, and we don’t know where [the outcome] is going to fall within that range. Often we don’t even know what the range is.”

Or as Elroy Dimson of the London Business School put it,

“Risk means more things can happen than will happen.”

The future can only be guessed at.

So, we must think about the future in terms of probability.

What’s most likely to happen?

What other outcomes are nearly as likely?

How likely are they and what would be their consequences?

What are unlikely events?

Even if we’re right about the possible outcomes, we still don’t know which one is going to happen.

Risk is generally inescapable.

Think of it this way:

  • Many outcomes are possible
  • We can’t know which of them will happen
  • At best we can list them and assign them probabilities
  • Even if we do so correctly, the actual outcome will still be in doubt
  • Invariably some of the outcomes that materialise will be unpleasant.
  • The uncertainty surrounding which outcome will materialise and the possibility that it will be a bad one (i.e., move us further away from a goal) is the source of risk.

Many people think the way to make more money is to take more risk.

I disagree.

If riskier investments could be counted on for higher returns, they wouldn’t be riskier.

I think increasing risk increases an investment’s expected return. It increases the range of possible outcomes; and therefore, includes some that are undesirable.

So, how should risk be dealt with?

My answer is through honest conversations and asking great (and deep) questions.

Do you understand the risks involved in reaching your goals?

How realistic are your expectations regarding the possibility of loss?

Can the risk taken be reduced through diversification?

Warren Buffett says,

“It’s insane to risk what you have and need to get what you don’t have and don’t need.”

In other words, you mustn’t let the allure of big potential returns cloud your judgement and blind you to the possibility of losses that exceed your ability to bear them.

Risk is a serious matter.

If you’re looking for guidance on how realistic your expectations are regarding return and the possibility of loss, my team and I are here to help.High performance professional, email community - Sam