Thinking About Risk

Risk is a buzz word. Nearly without meaning in everyday use. Few people actually think about it and so have emotional responses. Emotions cause action; rational thought seldom does. Others can easily use risk to alter your perceptions of value.

There are some ways to think about it so you can have a combination of rational thought and emotion. Emotion to motivate and rational thought to discover the target of the emotion.

It is two part. How do you relate to risk and how does risk relate to you?

Tolerance for risk is something all investment advisors assess. It means little unless the client understands the idea of risk. People fear things they don’t understand or find confusing. Like the stock market. Many risk tolerance questions illuminate a lack of knowledge more than an awareness of risk tolerance. Knowing how you feel about losing is counterproductive until you understand more.

You know the market fluctuates. You will be wise to decide if that matters. That could change your tolerance. 

Capacity for risk, is easier to see. How big is your margin for error? If I lose my favourite BIC Atlantis ballpoint pen, will I be devastated? Probably not. So I spend little time, trouble or expense to make sure it remains where I want it. I have the capacity to lose it without effect. Along the same line, I would do things my doctor recommends to preserve my health. I am not indifferent to that loss. The idea applies to investments the same way. If the potential loss is large enough to care about, I should take more pain to reduce the risk of that loss.

Exposure matters. Consider the investment loss potential. Permanent loss or temporary is an important thought. Variations are not losses until you sell the position or violate a lending ratio requirement. You must crystallize a loss to make it real. 

Many never think about external exposure. These are considerations other than the portfolio itself. In isolation, you cannot manage an investment portfolio for personal risk.

Suppose you are approaching retirement and your advisor says your portfolio should be 45% in equities, 45% in bonds and 10% in cash. The allocation is touted as ideal for someone your age with your investment risk profile. 

The reality is different. That allocation is meaningless because almost no one has a portfolio that constitutes their entire wealth. 

If the client owned a business that was worth 10 times the portfolio, would it still make sense? The client has all the equity risk they need in the business. Maybe 100% fixed income makes more sense. For someone else, if the portfolio is everything they own except their home, maybe it makes sense. If they are going to sell their home in two years, what is the right mix? The house is an equity investment, right?

To be effective, think globally and understand the risk of loss in terms of its consequence and in context.

You can’t do that until you know what you mean by risk.

In financial theory risk is volatility. Quantitative . How predictable is the outcome? predictability is fairly high value for most people, but markets don’t care about that. Markets are volatile and the shorter the period that you observe, the more volatile they are. Advisors like low volatility portfolios because the clients don’t panic as often.

Over long periods of time, the equity markets have earned around 10% before fees. To the extent they reflect how businesses in general work, there is little evidence to suggest the future will be very different. So the enemy is how often you look. If you look every day you will have huge volatility relative to the rate of return implicit in 10% per year. Roughly 0.038% per day. The S&P500 changing from 2349.1 to 2350.  No one would even notice that, but compound growth over a long time is quite powerful. Don’t listen to the volatility noise of the daily market.

In real life, risk is qualitative and that is the one people first think of and assume applies to the stock market. If I am struck by a car and become disabled, qualitative problem. No amount of time will fix it. In the stock market, a company goes bankrupt is different than if the stock price falls 20%. You cannot rationally think about those as somehow equal. Bankrupts don’t recover.  Microsoft at $40 per share is about the same company as it is at $50. Some other day it will be $60.

Think about the whole deal in terms of time. Time is part of capacity.  If you can wait for the market to average out, there is less risk.  If you need your entire portfolio on August 22, 2019 at 10:00 am, things are different.

Think about managing risk. Business owners do not see risk the same way as you and I. If you know plan B and its children, and you know how to quit plan A, maybe risk is not such a big deal.

Once again, it is all about context. If you fail to start with context you will not get the risk assessment right.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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