What is a risk? And can you handle it?

Are you ready to suffer from what could be a rough stretch for the global market? Here, we will help you to re-recognize the risks. Discuss how to define and measure risk, how investors experience risk, and how they can manage it.

The most common definition of investment risk is rooted in uncertainty. How likely is the return on your investment to deviate from your expected return? There are many ways to measure this possibility, the most common of which is the standard deviation of the returns mentioned above. This number helps investors understand how much returns can fluctuate around the average. This is a simple, widely accepted and unsatisfactory metric.

Standard deviation is inadequate in some respects. It treats downside risk (bad type) and upside risk (good type) equally. Nor is standard deviation a measure of the shape of the distribution of returns, nor is it a direct measure of the magnitude of the tail event, the episode that results in the greatest euphoria and bowel rot.

Of course, other risk measures address these shortcomings. Indicators that distinguish between good and bad volatility include the Sortino ratio and Morningstar risk. The Sortino ratio is a variant of the Sharpe ratio, which is the most common indicator of risk-adjusted returns. Both ratios include excess returns that exceed the numerator’s risk-free rate. However, while the Sharpe ratio is characterized by the standard deviation of the denominator (which also treats good and bad risks as equal), the Sortino ratio is only divided by the downward deviation. This gives you a more accurate picture of your return on investment per unit of “bad” risk.

Morningstar Risk has a slightly different view of risk. Instead of completely ignoring the good risks, we focus more on the bad risks. Calculated in comparison to other companies in the fund’s Morningstar category, this indicator is incorporated into the Morningstar risk-adjusted returns that underlie the fund’s Morningstar rating. Both of these measures distinguish between good and bad risks, but they still cannot capture the worst and worst risks.

The most common way to size the left tail (bad) sting of the return distribution is maximum drawdown. Maximum drawdown captures the decline from the peak of investment to the trough over a particular period of time. It’s not the worst scenario (you’ll lose everything), but you can see how much pain awaits the bear market.

All of these risk indicators have some usefulness in framing investor expectations, but I think they are still inadequate. I don’t think spreadsheets can measure risk properly.

What are the real risks?

The real risk lies in how to respond to the ups and downs of the market. The variability that the numbers above are trying to explain is the net result of human behavior in flesh and blood. We all respond to signals from our environment. These signals are produced and interpreted by a mass of gray matter wired for survival. We are inherently risk-averse. The real risk is that we do the wrong thing at the wrong time and go off course to reach our goals. It is impossible to convey that with data.

This notion of risk is so personal that it is ridiculous to measure. How investors experience and respond to risk depends on their personality, circumstances and experience. Investor risk appetite can fluctuate depending on the market. It may also change over time.

Investor risk tolerance is partially driven by personality. Some people are wired to look for risk in the market or by jumping off the plane. Others prefer to keep their feet firmly on the ground and play safely. Then there are skydivers who hold cash under the mattress and actuaries who like to bet on ponies after work. Importantly, the risks are personal.

Of course, the investor situation also affects the willingness and ability to take risks. Investors who have accumulated significant financial assets may be more capable of taking risks, but may want to maintain capital and therefore do not want to take more risk. .. The investor’s ability to take risks also depends on time. Recent graduates who are the first to contribute to an employer’s pension system are well equipped to seize opportunities, given the potential for decades of savings and investment before retirement. Investors approaching retirement may be less able to take risks as they shift their retirement spending from accumulating financial assets to relying on them. None of these considerations are included in the standard risk measure.

Investor experience also influences the relationship with risk. People who have lost huge amounts of money in the market in the past may be worried about taking risks in the future. Serial entrepreneurs may be more accustomed to risk than men and women in the company.

Attitudes toward risk change with the market and evolve over time. Ask us to assess your willingness to take risks in the year of entering the bull market on December 31, 2019, at a relatively calm time. Willing to pour it. Three months later, ask me again with the depth of sold out due to the coronavirus. Perhaps I’m not a little cavalier. Our attitude towards risk is constantly changing.

How to manage risk

There are several ways to manage investment risk. I put them in three buckets: asset allocation, investment choices and actions. Ideally, the first two should be optimized third. Perhaps the most effective way to manage risk is to choose the right combination of assets. Investors with high pain thresholds should prefer stocks. Those who are more squeaky should lean towards bonds and cash. It’s difficult to get the right balance. Just because an investor doesn’t like the ups and downs of the stock market doesn’t mean she can afford to skip her ride if she wants to reach her goals.

At this point in the market cycle, it makes sense to rethink asset allocation. Given the relative performance of equities over the last decade or more, many investors may be focusing on equities and downplaying bonds, despite the recent sale of both equities and bonds. .. In this case, it may be time to rebalance to a better mix. The right combination will ultimately depend on many of the above situations (risk tolerance, ability to take risks, personality, experience, etc.).

Investment choices are another way investors can ratchet their risks. Large-cap stocks are generally less risky than small-cap stocks. US stocks will be less volatile than emerging market stocks. Government bonds are safer than corporate bonds.

Finally, one of the most important sources of risk is what we look in the mirror every day. Inappropriate decisions about asset allocation and investment choices can easily take us off course. Therefore, the choices made for the first two buckets need to be optimized. The best portfolios are the ones you are most likely to stick to when things go wrong in the market. Trying to solve this is the best way to manage all the greatest risks.

What is a risk? And can you handle it?

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