A Closer Look at Investment Risk

What is Risk?

The other day, I participated as a guest speaker in a panel discussion for a virtual Financial Planning and Wealth Management Summit, and the question of "risk" came up.   The precise context of the question was how risk should be evaluated when working with women entrepreneurs.   Listening to the other panel members' responses reminded me of how poorly the concept of risk as a whole is understood, let alone managed, in the wealth management industry by most financial advisors.

For starters, there are up to five distinct types of risk that need to be considered, measured, and managed.  You can learn more about these five distinct risks by viewing our insight entitled, "Evaluating the Big Five Retirement Risks Every Retiree Faces."  As is often the case, "risk" in the context of the panel discussion was pertaining to investment risk.  Investment risk is the most commonly thought of risk because it's the one that is typically considered.

What is Investment Risk?

Investment risk is the risk that actual returns will differ from the expected return outcome at any point in time. No one knows with certainty what the future holds, so we look to the past to make observations about how certain asset classes performed. Taking specific note of each asset's average return and the variability of return experienced around that average return, known as standard deviation. From these observations, one can typically make a reasonable long-term forecast of future expected returns.

Stocks have a higher potential for return but also higher variability in the path of return. In contrast, bonds have lower return potential but also less variability in the path of return. The greater the allocation to stock in the investment portfolio, the greater the expected return and the higher the investment risk you are taking. Some individuals can tolerate wider swings in their investment portfolios' performance in the search for higher returns, whereas some individuals cannot comfortably "stomach" such swings.      

There is More to Consider than Asset Allocation

Advisors are often consistent in explaining investment risk as the volatility of return potential a portfolio presents.  Advisors are also consistent in trying to manage this risk through making an appropriate asset allocation decision between stocks and bonds.  However, seldom is consideration ever given to the portfolio's actual construction.  How a portfolio obtains its stock and bond exposure matters a great deal when it comes to investment risk.  As an extreme example to make the point, a portfolio whose stock exposure is made up of three large-cap stocks presents an entirely different investment risk profile than a portfolio with a single index fund representing the global stock market.

I would argue that the definition of investment risk as volatility of return potential is incorrect in the portfolio with just three stocks.  The definition of investment risk in this portfolio would be a permanent loss.  This portfolio has company-specific risk that has not been diversified away.  If one of these three companies were to go bankrupt due to some unforeseen circumstance (i.e., think Enron and General Motors), this portfolio would permanently lose a third of its stock value.  

In the portfolio that holds a global stock index fund, the fund's value would decrease when times got tough, but even if a few dozen companies went bankrupt, the fund's value would barely be affected.  This is because, given it's thousands of holdings, all diversifiable company-specific risk has been diversified away.  The definition of investment risk here is truly fluctuation of value at any point in time or volatility of return potential.

This example was extreme, but I routinely review portfolios that lack material potential exposures that end up increasing the amount of investment risk a person faces given a certain asset allocation.  Having a maximally diversified portfolio at any given asset allocation level will make it less likely to experience the volatility that a portfolio with investment concentrations is likely to have.

Dimensions of Risk Evaluation

The other issue I often see, and it was on full display during my panel discussion participation, is the over-simplification of the evaluation process to just a person's risk tolerance.  The evaluation of investment risk (and all other risks) should consider three distinct dimensions.  It is not just a matter of whether someone can "stomach" return volatility.  Three dimensions must be considered and measured to make a proper evaluation:

1. Need – How much risk (i.e., stock exposure) is needed to achieve your goals
2. Willingness -  How much short-term market volatility you can tolerate before it starts affecting your sleep or makes you feel panicked to the point you want to sell stocks after a market downturn
3. Ability – Are you in a position to be able to take the risk you need to take, or are willing to take

Evaluation starts with understanding the amount of risk, or stock exposure, that may be necessary to achieve your goals.  The rule of thumb is to take only the level of risk needed to meet your goals, though obviously, there is much more to consider.  Your willingness to take risk is known as your risk tolerance.  Your willingness is a measure of how much volatility you can "stomach."  Once you understand your willingness to take a risk, you must check against your ability to take a risk.  Your ability to take a risk is measured by looking at your personal situation to see if you have the resources and flexibility needed to afford to take the risk without causing undue stress or harm.  Your ability to take risk overrides your need and willingness to take a risk. Even if you are willing to take more risk than you have the capacity for, you will be constrained by your risk capacity. You cannot bet what you cannot afford to lose.

Risk Management is Important

Proper risk management is a crucial aspect of retirement planning.  Risks represent the possible events that could occur and get in the way of you realizing your goals and living your best life in retirement.  Risks are also what present you with feelings of fear.   The act of retiring subjects a retiree to five unique risks. It would be best if you took the time to understand your feelings toward the various risks to which you will be subjected. A proper retirement plan will seek to manage the risks to which you feel averse to a level you find palatable so that you can feel at ease, thereby increasing the probability of staying on course with the plan.  To learn more about managing all five unique risks, see our insight entitled, “Managing the Big Five Retirement Risks Every Retiree Face.”

We stand by ready to help if you need assistance in assessing your risk management strategy. If we can ever be of service, please feel free to reach out.

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ABOUT THRIVE RETIREMENT SPECIALISTS

Thrive Retirement Specialists is a retirement planning specialist dedicated to delivering a more thoughtful and strategic approach to retirement planning for those nearing or in retirement. We are a fee-only Registered Investment Advisor (RIA) offering a single, flat-fee service entitled ThriveRetire^TM that goes far beyond what has traditionally been known as retirement planning.  ThriveRetire™ is an engaging ongoing 8-step retirement planning process and investment management service that seeks to identify all risks, assets, tools, and tactics to develop an optimal retirement plan designed to support your ideal retirement lifestyle and goals to the fullest extent possible.  With every interaction, we seek to inform and serve, so our clients can safely trust their ThriveRetire™ plan and process, leaving each client with the confidence and peace of mind to live a vibrant and full life through retirement.

ABOUT ANTHONY WATSON, CFA, CFP®

Prior to founding Thrive Retirement Specialists, Tony spent eight years serving as the Chief Investment Officer of a firm where he provided advice and investment management services to over 600 individuals representing at the time over $1.5 billion of investments. Before this, Tony served as Vice President at J.P. Morgan Private Bank, where he advised high- and ultra-high net worth individuals on all matters of wealth, including investments, portfolio construction, portfolio management, and retirement planning.

Tony lives in Dearborn, Michigan, with his wife Dawn and daughters Emma and Anna.

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