Modern portfolio theory (efficient market hypothesis) has been the standard of the investment industry for decades. With this approach, “risk” is defined as just one thing, volatility. That means a portfolio or an individual security that historically has had greater changes in value than the overall market within the same timeframe will be deemed to have higher risk. This methodology persists because it is easy for computers to surf databases of past stock price movements and calculate the volatility factor for each individual security (standard deviation) and compare that to the volatility of the market, to produce a single risk factor (beta). I find this approach to be inadequate and likely misleading to individual investors.

 

I am not the first one to have a problem with this methodology. Many other industry professionals have expressed similar sentiments, such as Jason Voss and C. Thomas Howard  in a CFA Institute blog on April 17, 2017, or William Smead of Smead Capital in a blog entitled “Risk is Not High Math” (January 25, 2018) where he writes “Emphasizing variability / stand deviation is saying that the ride is more important than the result…”.

 

There are two major problems with defining risk as simply volatility. First, it can cause people to stay away from higher-beta investments that might be deemed too risky even when there may be higher-volatility securities that would be suitable for someone’s specific portfolio requirements. Furthermore, it is often the best time to buy the market, or an individual stock, after a sharp decline like the one we experienced in late 2008. But such an incidence of increased volatility would cause beta factors to rise implying higher risk - if volatility was all that mattered. Yet buying at rock-bottom prices would actually reduce one’s risk by providing a greater margin of safety, purchasing at a discount to true underlying value. If you are climbing a ladder, you have less risk from a potential fall the closer you are to the bottom rung.

 

A much greater problem with defining risk only as beta is that this ignores many other risk factors which, frankly, should be of greater concern to investors. But first let us examine one clear situation where volatility alone represents considerable risk. If you have to rely on the sale of investments to finance a major near-term expenditure, your plans could be jeopardized if the market were to post a sharp decline before the investments could be sold. Prices might not recover in time for you to raise the necessary cash when you need it. In a simple retirement scenario, a $2 million stock portfolio could support 20 years of retirement spending at $100,000 per year, but a sharp market decline similar to 2008 in the first or second year, requiring another 10 years for prices to recover, would leave you with only enough capital to last 10 years instead of the 20 you expected.  Alternatively, you might be forced to cut your retirement spending in half.

 

This is a possible scenario where volatility does represent real risk. But it should lead one to conclude that the greater risk is not having saved enough for retirement in the first place. And this also shows why building income portfolios can reduce volatility risk because you would not have to sell any investments to pay expenses if your monthly spending was more than covered by cash flow generated each month from your portfolio.

We can categorize risk factors other than volatility into three groups: macro risks, business risks, and risks associated with investor behaviour. Macro risks are generally well understood. These include rising interest rates, higher inflation, a decline in the domestic currency, sharp movements in commodity prices, changes in tax regulations, and geopolitical risks (like Brexit or trade wars).

 

Business risks are key because failure of an issuer of securities could lead to a permanent loss of capital for holders of those securities. These are risks that company management and directors worry about. That is why one of the greatest risks of all is poor management, because management is the first line of defense against various business risks. There is a long list of potential risks to any business: too much debt, labour issues, government regulation, competition, new technologies that may impact the business model, etc. For some businesses, changes in macro factors, like commodity prices, interest rates, and foreign currency movements, can also be significant risks. As a CFA and former securities analyst, it has been my responsibility to evaluate such risks for various investments and weigh those against underlying value and potential for future returns.

 

Comparing business risk to stock price volatility, “Volatility is good; risk is the possibility of permanent loss of capital” according to Prof. George Athanassakos writing about value investing in the Globe and Mail. Also, “Thoroughly understanding a business is a far better form of risk control than focusing on a stock’s past price behaviour” writes EdgePoint Wealth Management .

 

Investor behavioural risks are more difficult for people to recognize but they can be significant. A large risk to retirement is not saving enough capital in the first place, as mentioned earlier. Also, spending more than you should in retirement relative to the amount of capital you have is a serious risk – everyone should have a financial plan to prevent this from happening. Specific investment behaviours  that can be dangerous are common, like not having a comprehensive portfolio strategy, overly concentrated stock positions, not diversifying internationally, poor security selection, paying too much, chasing a “hot” stock, frequent trading instead of having the patience for long-term investing, assuming recent market performance will extend into the future, having too much leverage, etc.

 

Certain human psychological traits can lead to excessive risk-taking. It is common for people to rely on advice from a trusted source that turns out to be wrong instead of doing proper due diligence. There is the risk of being over-confident, thinking you know something when you really don’t, instead of consulting an expert. Perhaps the greatest risk is a possible “black swan”, a major event impossible to foresee. Assuming the future will be the same as the past often gets investors into trouble. 

 

At Friedman Investment Group, we work hard to understand all the various risks related to the securities we own, not just the volatility risk. And, for our clients, we provide a steady hand to keep their portfolio strategies and financial plans on track, helping them avoid ill-advised behaviour that might result from emotional reactions to events. Perhaps you should contact us to learn more.

 

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