January 6, 2022
Sid Roy
All of us know there are risks in managing investment but that is where most people stop. This risk is somewhat confusing to get a grasp on. The lack of understanding can lead to bad investment decisions. It can also stop people from investing at all due to fear. As part of the Ask-Listen-Share series, we decided to focus on understanding and measuring portfolio risk in January.
The first question is – what is risk? The most common understanding of risk is the chance of losing principal money in any investment. This is the dominant and most visible risk. We also know how to measure it and sometimes that can lead to false sense of security.
The second type of risk is volatility of returns. The investment returns can vary from year to year. And this means that you might not have the money when you really need it. The volatility of investment returns is also the conventional measure of risk. It is easy to measure and helps to compare different types of investments. This is what investors might focus on due to the pervasiveness of news media fixation on volatility. However, it is debatable, whether volatility is really a risk.
One of us came across a simple yet clarifying presentation of risk: “investment risk is nothing but not having the money when you need it”. If we take this perspective, then volatility is not really the problem. The real issue is in making the right choices in mix of investments so that you have money you need for a specific purpose when you need it.
The third category of risk is the most insidious of all. This is the risk of opportunity cost. Let me give a simple example: let us say you are holding Amazon stock, and it has appreciated a bit during the year. Now you might feel happy with your investment that you have not lost money. However, if you compare it to a market benchmark such as S&P 500, it might not look that good. In 2021, S&P 500 return was around 25% compared to the single digit rise of the Amazon stock. The danger is that you might lose out on substantial gains if you do not pay attention to this type of risk, and you may not even be aware of the opportunity cost. This is not a statement about the quality of Amazon stock, but about the awareness of its relative risk-adjusted performance compared to other alternatives.
Now another consideration on the above is – if you are happy with the small but positive return that your favorite stock gave you, you might be able to afford lots of investment options with lower volatility (i.e., risk) compared to what you own. Since you took a higher risk, you should get a comparatively higher reward. This fact is not that obvious by following daily updates of stock prices, and it is easy to be tripped by this risk.
We have talked quite a bit about the various shades of risk. There are several measures starting from standard deviation in investment returns to others such as the Beta, maximum drawdown, etc. However, they are sometimes hard to use from a practical perspective for common folks.
So, given all the nuances and our comment earlier that volatility is not a very complete measure of risk, what does one do? How do we measure risk then? This is a clearly a very big topic. One simple way of getting a grip on this is to focus on at least getting the market return and accepting what is known as the “systematic” risk associated with the market. Systematic risk is the risk associated with uncertainties of being in the market. This kind of risk is beyond our control, and unlike idiosyncratic risks, it cannot be diversified away. So, we accept that as fact of life.
As an example, this might mean that you might invest all your money in an index for the total stock market. And then you are going to get the return from the overall market and accept the inherent risk of the overall market.
If your portfolio is not as simple as that, then there are two other indicators you might want to look at to get a concrete sense of the risk you are running. One is draw down – this is the maximum decrease that a portfolio might see from its peak, and another is the time it takes to recover – this is the draw down period. Taken together, this will give you a sense of what your situation could be like with a particular portfolio allocation strategy. As an example, let us say you have a $10,000 portfolio right now. If your current portfolio has a potential drawdown of 50% and a drawdown period of 5 years, consider what happens if you do not have access to the full $10,000.
Let us sum it up into actionable steps. First, you might want to start with some idea of your expected return and look at the common styles of portfolios such as a mix of 40% bonds and 60% stocks that match your expected return. Second, look at the drawdown and drawdown period that a particular allocation might have. Consider, if you can live through the drawdown period without compromising your most important goals. Third, within each type of investment such as fixed income or stocks, you might want to consider how your return/risk for investments compares to a common index. If you are happy with your current return, you might want to look for comparable options that come with less risk (volatility).
That is all for this month. It was quite an engaging discussion, and we will see you next month.