What You Think is Risk, Is Wrong!
I hope I got your attention with the headline.
But I mean it and will set out here to make my case.
Please tell me, how does it make sense to do an in-depth risk-tolerance profile for a new client when the industry still clings inadvisably, mistakenly and desperately to the false notion that – Risk is Volatility?
Risk Is Not Volatility!
What is risk if not volatility?
Is risk the potential loss of capital? NOPE.
I am confident negative returns feel worse than positive returns.
And big negative returns alter investors’ perception of risk far more than small negative returns.
So, what is risk?
The two most popular and often used measures of risk are the Sharpe Ratio and the Sortino Ratio.
Half a century ago, Sharpe came up with Modern Portfolio Theory which assumes every investor has the same investment goals – maximize the level of return for a given level of risk.
It was a simple calculation for measuring the return investors should expect for the level of volatility they are accepting.
It became the cornerstone of modern finance.
Sortino introduced his ratio some years later.
The Sortino ratio focuses solely on downside volatility, which is all most investors are concerned about.
In a Wall Street Journal Heard on the Street article published in 2005, a few years before the 2008 crash, both Sharpe and Sortino outlined how their respective ratios can be misleading and manipulated and how neither wants his name associated with their flawed measures of risk.
Sharpe is quoted in the article saying, “Past average experience may be a terrible predictor of future performance. Anybody can game this – I could think of a way to have an infinite Sharpe Ratio.”
Sharpe himself does not use the ratio in his analysis.
Neither of these world-renowned Economists uses these ratios. So why do most firms?
Why, 15 years later, are these two flawed ratios, rejected by their developers, still the standard for a measure of risk for Investment Advisors and the Industry?
Even if the ratios are not manipulated, Sharpe says, they do not foreshadow investment woes because no number can.
Neither formula can predict trouble before an investment quickly heads south.
Nor can the ratio account for an extreme unexpected event.
Long Term Capital Management had a glowing Sharpe ratio (4.35) before it collapsed in 1998 when Russia devalued its currency and defaulted on debt.
Beta, too, is ineffective at judging risk.
Lehman Brothers had a fairly benign beta while leveraging itself up 40 to 1 before going bankrupt in 2008.
Risk in any investment is altered psychologically and fundamentally by price action.
Think about this as an axiom: an investment becomes less risky as the value declines, assuming fundamentals remain essentially unchanged.
True, but counterintuitive for most.
With over 40 years in the investment business, I have found it difficult at times to be unemotional and increase investment in an asset that has declined meaningfully in value.
However, this fundamental exercise is how the famous (just ask him) Warren Buffet succeeded in accumulating a legendary track record early in his career.
As an investment declines in value, the risk in the investment declines.
One must have faith, assuming the fundamentals remain unchanged.
(I should reiterate, assuming fundamentals remain constant. Years ago, The Capital Group did a study indicating when an investment gets crushed on fundamental deterioration, it takes an average of 16 months before investors return to the wounded investment. Again, I am assuming there is no fundamental deterioration.)
The foundation of investment management is to get at the answer to the following question, “What is your purpose for investing?”
If you are willing to take the client through an exhaustive risk-tolerance questionnaire to gauge their appetite for volatility, wouldn’t it make so much more sense to spend that time determining: What are you trying to accomplish by having professional management of your assets?
Only when this question is successfully answered can an investment manager know what rate of return is required for the client to achieve their desired goals.
Only once this rate of return target is determined can an investment plan be made to achieve the required rate of return.
A recent study demonstrated gender plays a fairly significant role in the decision-making process when faced with investment risk.
Men are more prone to risk-taking strategies while women tend to trade less and be more personally invested in their financial decisions.
But in the end, these factors have absolutely nothing to do with the rate of return required to reach their investment goals, man or woman.
To paraphrase Harry Kat…
Learn more how you can approach the issue of risk.
Or talk to us to see how you can leverage the ERO technology to eliminate investment uncertainty.
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