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Evaluating Risk Is Not The Same For All Investors
The concept of risk is a topic often referred to, and for good reason: It
is vitally important to investment strategies. Complicating matters, however,
is the fact that there are almost as many ways to define and measure risk
as there are different types of investors, so how do you know which is the
right one to use?
I would suggest that the answer really depends on what kind of investor
we are talking about and what investment objective they are pursuing. I think
the best way to illustrate this concept is through the context of the relationship
between individual investors (you, our clients), diversified multi-asset
managers (us, your investment manager) and more narrowly focused money managers
(whom we invest in on your behalf).
Individual Investors
Every individual investor has their own unique investment
objectives and considerations, and those should be translated into specific
investment goals.
(Part of an individual investment manager’s role is to help their clients
in that process if needed.) While different for each investor, once those
specific goals are determined, the most relevant definition of risk for the
individual is the same: the inability to meet those goals.
This is often called “shortfall risk.” Falling short of your
goals is failure. Reaching or exceeding them is success. Therefore, maximizing
the probability of achieving one’s goals, not the maximization of total
returns, is what is truly important.
This last point is critical. It means that one shouldn’t take on excessive
risk if they don’t have to. If maximizing one’s probability for
success can be achieved with a more conservatively positioned portfolio,
then that is the appropriate portfolio to have.
Many investors, however, want the portfolio with the highest expected return – even
if it means they are actually decreasing the odds of meeting their long-term
goals. Let me give you a (very) simplified example. You want to buy a tricycle
for your newborn daughter when she is four and it will cost $120, and you
have $100 to invest. Currently, 4-year Treasury bonds are paying 5% interest.
If you invest in a Treasury bond and hold it to maturity, in four years you
will have $121 and change — guaranteed — a 100% success rate.
Given that stocks have typically generated twice that return, or 10% a year,
you might argue to put that $100 into stocks. If they only do half as well
as expected you can still get the bike, and if they deliver “average” performance
you could add a horn or maybe buy a fancier bike.
But then, of course, you might experience four years like 2000-2003. After
those four years, $100 invested in the S&P 500 would have declined to
$80 and you would have to tell your little four-year old she’ll have
to wait several more years for her bike. By choosing to take more risk than
needed even though it offered a greater potential return, you failed to achieve
your goal.
As human beings, we have fears and appetites. Money, or the perceived lack
thereof, often amplifies these concerns and desires. That’s why it
is not easy to stay the course with a disciplined investment program, especially
when the markets are making big moves (in either direction) and the media
is breathlessly fanning the flames.
An investor has some control and influence over some of the key factors
for long-term investment portfolio success: how much they can save, how they
will manage their money (whether they do it alone or have a professional
do it), and how that money will eventually be spent. Something that can’t
be controlled is the behavior of the financial markets. Not only can’t
investors control or predict future rates of return, but they also can’t
control volatility.
The Diversified Money Manager
Diversified multi-asset money managers (like
Kobren Insight Management), who are investing money on the behalf of others
(often as the core or entirety
of a clients’ investment portfolio), are attempting to maximize total
return for an appropriate level of risk. In this case, risk is typically
measured or managed in terms of “volatility”.
What is an appropriate level of risk depends on each individual investor.
Whether working alone, or with an investment professional, one needs to continually
assess objectives, time horizons, personal financial situation, risk tolerance,
and other unique considerations. Each of these factors can modify one’s
asset allocation and exposure to volatility. If working with an investment
professional, this should be a constant dialogue and the definition of appropriate
will evolve over years in the relationship.
Volatility is often defined as the statistical measure of “standard
deviation”. Being able to quantify a number definitely gives the appearance
of control, which can be misleading. Volatility is much squishier than that
and how destabilizing volatility is depends on each investor. Nonetheless,
there are various studies demonstrating that lower volatility investment
products are easier for most investors to stay with.
Volatility is destabilizing. Volatility creates emotions. Volatility gets
investors off track. This isn’t just a reference to downside volatility,
but also upside volatility. A sudden price surge higher can shake many investors
out of investment programs just as easily as sharp market corrections. There
have been a variety of studies that have shown that investors are more likely
to stick with less volatile investment programs.
The bulk of many investors’ assets are in multi-asset portfolios.
In other words, even long-term investors own a variety of asset classes including
stocks and bonds. A common question, however, is why own bonds if I am investing
for the long-term (not just the four years in our bike example) if stocks
generate a higher expected return over time?
The reason is that the introduction of bonds, and other non-equity asset
classes, diversify equity-dominated portfolios and bring down over-all portfolio
volatility. In other words, a multi-asset portfolio should provide a smoother
ride and one that more investors are likely to stay with.
In fact, holding a diversified portfolio may allow investors to actually
maintain a higher average allocation to equities over time. That is because
investors who go for 100% equity portfolios are also more likely to make
dramatic asset allocation decisions and move out of stocks for significant
periods when the markets get volatile which lowers their average allocation
to equities. In addition, it is likely that they will have exposure to equities
after the market has become overvalued and will not be in the market when
it is undervalued.
The Focused Money Manager
For the more narrowly-focused money managers that
we select to manage a segment of your total investment portfolio we need
a different way to look
at risk. We deem a focused money manager successful if they provide the expected
market exposure and generate superior security selection within that market
segment relative to their peers.
At KIM, when we analyze focused money managers that may be utilized in our
diversified portfolios, volatility is not the key definition of risk. Here,
the definition of risk is a bit more subjective and involves the lack of
quality decision-making. As one of the investment industry’s leading
voices Peter Bernstein has said: “Risk management is quality decision-making
in the face of uncertainty.” In other words, for our underlying fund
managers, the key risk is that in tough times, they might lack the discipline
to stick with their investment process.
This isn’t easy to measure, of course, but it is critical to understand.
When we select funds for your portfolio, they have a specific role and function.
If they don’t serve that role, then your over-all portfolio will not
behave as we expected.
Interestingly, a good time to assess whether or not a manager is disciplined
to their philosophy and process (and not simply chasing performance) is when
their relative performance is poor. If the fund’s manager(s) is sticking
with their long-term investment discipline and the market is simply not rewarding
that style of management at present, this can often be a good time to buy
(or hold) these funds. Ironically, this is often the same time when many
individual investors are redeeming the same manager.
Great fund managers always seem to dismiss volatility as a risk measure
for their own portfolios. They tend to focus on a specific style of investing
and within that style they look for the best companies to invest in, not
necessarily the companies that have the stocks with the lowest stock price
volatility. They often cite the key risk measure as something like “business
risk,” “management risk,” “valuation risk,” or
the like. In other words, a security is riskier because its valuation is
higher, management is less able, or its growth prospects are lower, not because
it has higher stock price volatility.
Still, why shouldn’t we use volatility for evaluating the risk of
individual mutual funds that we might want to buy for your portfolio? Don’t
most mutual fund discussions and fund rating methodologies incorporate volatility
(or a similar statistic)? When we evaluate an individual fund, volatility
is simply a descriptive statistic. We are neutral on whether a fund is high
or low volatility. We are simply trying to understand how volatile a fund
is and how the fund will behave over time.
In fact, if anything, we prefer a fund to have higher volatility relative
to peers, as that probably means they are more likely to be fully invested
and providing a “purer” exposure to what we were seeking from
them. Yet, most discussions or ratings of funds with similar returns will
typically favor the lower volatility option because it offers a better risk-adjusted
return. It sounds good, but, in fact, simply using risk-adjusted measures
to select individual mutual funds could lead to poorly constructed portfolios
(never mind some less than optimal fund selections).
A fund’s volatility is an incomplete picture for understanding its
risk profile and characteristics, particularly when building a diversified
portfolio. Perhaps even more important, we need to know how a each fund complements
other funds in your portfolio. A statistic that attempts to quantify this
is “correlation.” When it comes to a fund’s risk characteristics,
in terms of your overall portfolio, it is often better to have a lower correlation
to the broad market and to other funds you own, than to have low volatility.
Nonetheless, that number is generally missing from most fund rating methodologies.
Summary
Risk is a key factor in evaluating investments, but it is very important
to remember that there is no one risk measure that fits all. In particular,
individual investors, diversified, multi-asset money managers, and narrowly-focused
fund managers need to use different concepts of risk. While risk-adjusted
performance is a good way to assess a diversified, multi-asset manager like
Kobren Insight Management, it is not necessarily a good way to measure the
underlying focused managers and funds that we buy for your portfolios.
At Kobren, we look for managers with a consistent, disciplined investment
philosophy and process. If we can find those disciplined managers, and they
continue to behave as we expect, then we should have the ability to effectively
manage the relative volatility of our client portfolios. And, as a result,
we should be able to provide an investment product and service that our clients
will be comfortable sticking with to achieve their long-term investment objectives.
Sincerely,
Rusty Vanneman, CFA
Director of Research
Co-Portfolio
Manager
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