In the financial context, the true definition of “risk” is the chance that an investment will lose value. But is that really how the financial industry defines risk? We believe much of the industry talks about risk as a matter of volatility and uses the term “standard deviation.”1
Yet, should volatility be an investor’s only concern? Can risk truly be quantified? Is one person’s risk the same as the next person’s?
It’s been our observation that the development of modern portfolio theory (MPT) and its resulting applications have given money managers and investors alike a false sense of security about portfolio-risk management.2 This is not to say that MPT has no place in portfolio management, but we feel that it lacks a crucial human element. People use their money and investments to support their lifestyle, heirs and charities. Since the life cycle of a family is not a precise mathematical endeavor, and neither is a family’s need for capital, this can impact the construction of portfolios.
Investors and their advisors would be wise to consider risk as the possibility that a permanent loss of capital may occur, and in turn, force a change in lifestyle. Wealth managers may find little comfort in mathematical precision and instead recognize the importance of experience. Famed British economist and author Ronald Coase, who passed away in 2013 at age 102, once said, “If you torture the data enough, it will confess anything.” So along the same line, we say that understanding and defining goals should be the basis for any portfolio construction.
Merely feeling confident enough, falsely or otherwise, to expect a certain outcome does not mean it will turn out that way.
Someone can say that, “The average return on a portfolio is 9 percent, with a standard deviation of 6 percent;” and, 99 percent of the time, the outcome will fall between 27 percent and -9 percent. Even as the market bottomed in March of 2009, you may have been asking, “How can this portfolio be down -33 percent? What happened?” And your advisor may have said that it was tail risk operating. (Tail risk refers to the least likely and most extreme outcomes.) “So, tail risk is different from regular risk?” you would have asked.
Much to the contrary, tail risk is a part of everyday life. Unfortunately, we are constantly reminded of this risk when we watch the news. Tragic accidents and natural disasters occur with seeming regularity. That helps explain why relying solely on the numbers can lead to complacency. Just remember the words of Coase. The truth is, the amount of possible outcomes is infinite. Merely feeling confident enough, falsely or otherwise, to expect a certain outcome does not mean it will turn out that way. (If you have kids or pets, you know this to be the case.)
Risk-taking, like many other things in life, is a subjective endeavor, much like the enjoyment of fine wine, cigars or luxury watches. The human element in risk is equally, if not more, important than the math. Knowing what amount of capital can be subjected to a chance of loss may be the most valuable definition of “risk” for any individual who expects to use that capital for life’s future pursuits.
If the unanticipated outcome cannot negatively impact your pursuits, you have already won.
1Standard deviation is a statistic that describes how close a set of observations is to the average of the set.
1Modern Portfolio Theory (MPT) was developed by Harry Markowitz in 1952. MPT demonstrates how investors use diversification to optimize their portfolios.
Thomas Mantione and Andrew B. Shantz are Financial Advisors with UBS Financial Services Inc. in Stamford, CT. UBS Financial Services Inc. Financial Advisor(s) engage Worth to feature this article. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the U.S. CIMA® is a registered certification mark of the Investment Management Consultants Association, Inc. in the United States of America and worldwide. As a firm providing wealth management services to clients, we offer both investment advisory and brokerage services. These services are separate and distinct, differ in material ways and are governed by different laws and separate contracts. For more information on the distinctions between our brokerage and investment advisory services, please speak with your Financial Advisor or visit our website at ubs.com/workingwithus. The strategies and/or investments referenced may not be suitable for all investors. UBS Financial Services Inc., its affiliates and its employees are not in the business of providing tax or legal advice. Clients should seek advice based on their particular circumstances from an independent tax advisor. Insurance products are made available by UBS Financial Services Insurance Agency Inc. or other insurance licensed subsidiaries of UBS Financial Services Inc. through third-party, unaffiliated insurance companies. The views expressed herein are those of the author and may not necessarily reflect the views of UBS Financial Services Inc., a subsidiary of UBS AG. Member, FINRA/SIPC.
This article was originally published in the April/May 2016 issue of Worth.