Managing Risk Means More Than Meets The Eye
Risk is what it is all about in the investment world. If there were no risk, everyone would be a successful investor, and there would be no need for an advisory industry. And yet, most investors do not understand what real risk is, how to measure it and how to better develop an investment strategy that makes sense for their particular situation. Merriam-Webster defines investment risk as “the chance that an investment will lose value.” But this does not adequately describe the nature of risk for one simple reason: All investments will lose money at some point.
Stocks, bonds and hard assets do lose money from time to time. What is less known, and even less understood, is that cash equivalents like certificates of deposit and money market accounts have a high potential for losing purchasing power because of their low returns after inflation and taxes.
So if we proceed from the assumption that all investments will lose money at some point, then it is really a matter of degree and duration. Professional investors measure risk as the range of returns above and below the average return. The greater the range of returns, the greater the risk an investor faces.
Take two hypothetical examples. Both have an arithmetic average return of 10 percent per year across 10 years. One investment did 10 percent per year each year. The other, although averaging 10 percent, had many years with returns well above and below the average, including some negative years.
Even with the same average return, a wider range of returns means the latter investment was riskier.
The riskiness of a wider range of returns rises because at any given entry point, investors could experience the historical return extremes, positive or negative. More importantly, the empirical evidence shows that these inflection points cannot be predicted.
Investors are therefore faced with a stark choice: Avoid market risk by investing in cash equivalents or accept that market risk is necessary and unavoidable to earn a real return after taxes and inflation.
The latter choice may be necessary for future retirees who will need to rely on supplemental inflation-adjusted cash flow from their portfolios. While most investors are worried about a repeat of 2008, when risk assets dropped significantly in value, they may be ignoring an even greater and perhaps more likely risk —they could outlive their money because they were too conservative.
Running out of money at age 85 doesn’t meet any definition of “safety.”
As seen in the 6/21/2010 issue of Washington Business Journal