Sunday, February 7, 2010

Risk: What my salesperson forgot to mention!

It may seem to many investors that the word "risk" is used in many different contexts without the author identifying what they specifically mean by risk? That is because "risk" is a term used to quantify many different investment issues that can lead to potential losses. So lets look at risk, its uses in the investment industry, and how the term is twisted to leave investors at a loss to understand what risk they are being asked to measure.

Risk is defined in "" as: The chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

Perhaps the first thing an investor might note is that "risk" is a statistical measurement, not a "feeling in my gut". The second point is that "standard deviation" measures risk of both higher and lower returns than were expected. I think its fair to say most investors personally define risk as only that part of the unexpected results that are negative. Few investors seek to avoid returns that were higher than expected. In short investors need to focus on "downside risk", understanding that upside risk (positive risk if you will) is generally proportional to the downside risk.

Risk Questionnaires: So I am filling out a "risk assessment" and need to identify the risk I am willing to take in my investment portfolio. Not surprisingly the the form does not define risk as a mathematical concept. In fact many of the questions talk about "feelings" and more specifically "hypothetical feelings". So, hypothetically, how would I feel if my investments dropped in value by 10% in a given year? This question is generally a "loaded question" as I am betting most investors would be embarrassed to say a 10% decline would scare them away from investing (especially the alpha male investors who equate risk taking with bravery!). So I would state unequivocally that this low level of risk does not worry me. Now the questionnaire has me thinking in terms of how brave I can "hypothetically be. If 10% doesn't worry me then how about 20%? Well I think to myself..... 20% is something to think about, but hey "no guts no glory" and what are the odds of actually losing 20%? In the end I saw off at 25% as my hypothetical maximum. Having said that we are talking about 25% as being a bizarre one time event which is hardly ever going to happen, right?

CONCEPT #1: Market drops of 30% or more have occurred 13 times since 1900 or, on average a little more than once every 10 years. Drops of 40% or more have occurred 9 times or approximately every 12 years. Losing 20% is likely to happen every 5 years! If you invest for 20-30 years you can bet you will see losses over and above your target several times.

Concept #2: Your losses will not be hypothetical! Your advisor will forget to mention an interesting concept she learned when entering the business: losses cause twice as much suffering as an equal gain would cause joy ( Prospect Theory). In short if you are told there is an equal chance of 20% gains and losses, the gain will feel good but the loss will absolutely devastate you emotionally. Think in terms of dollars and losses. If you saved your hard earned cash over the years and could lose $20,000.00 from a $100,000.00 portfolio in the next few weeks would you still want to stay invested? If you invest $5000/yr into your RRSP would you be okay if the last 4 years of returns were lost by a falling market? How about the last 6 years of deposits?

Risk and Time in the Market: If you have an advisor you have been told "we can take more risk because you are a long term investor. I can be assured of that because advisors want to tick the "long term investor" box on your application. If is basically a "get out of jail free card" for your advisor if you take too much risk and lose your shirt. Your wise advisor, having watched your money evaporate will tell you, with a great sense of false bravado, just hold the course and stay with me because the market will bounce back.... it always does! Should you decide to sell and sue your advisor the advisor will point to the "long term investor" box and say you caused your own losses by not staying invested for the long term! "Sorry Mr Investor but you said you could take risk and said you would not bail out of the market so don't look at me! It's all your own fault!"

Concept: Time in the market increases the likelihood of having large market declines occur. Your risk of catastrophic losses is not spread over 10 or 20 years, but rather it exists each and every year for the 10 to 20 years you might be invested. Since advisors cannot avoid the huge market drops (I think 2008 confirmed that for everybody) then you are at risk of the big drop occurring in every year you have money invested in the market. In short, keeping your gains fully invested is very similar to letting your bet ride at the craps table in Vegas. Look at every year in the market as another separate bet and make sure every year that you are only betting the amount you can afford to lose. Rebalancing a portfolio reduces risk as over time you can take profits out of the equity market and lower the percentage of a portfolio you have at risk.

Types of Risk: There are many types of risk so I will discuss only the two risks I think are most important to me.

Salesperson Risk: While I have lapsed into using the term advisor, your advisor or financial planner is actually a licensed salesperson. They typically earn money through collecting commissions which are often not disclosed to you even though you will pay the commission either directly (broker commission, flat fee) or indirectly (fund trailer fees, hidden fixed income fees, new issue fees). Most salespeople are paid to gather clients and are rewarded for getting your money into a mutual fund or generating fees off that money. Very few (think basically none) are paid a fee to manage your investments effectively. Whether you make or lose money has very little impact on the income of your salesperson so long as you do not leave the company he works for. Trusting your salesperson to effectively manage your money is a huge risk. Why do you think your salesperson buys mutual funds? It is because they do not know how to properly manage investments themselves.

Individual Security Risk: This risk is commonly called "un-systemic risk" and it refers to the concept of having too much risk in any one security, sector or industry. If you buy individual stocks you take unsystemic risk which can typically be minimized by holding 30+ securities. The catch is the 30+ securities also need to be diversified by geography, sector, and industry. Holding 30 small cap companies is less risky than holding 1 small cap stock, but it is much riskier than holding a mix of small cap , mid cap, and large cap stocks. Similarly you should diversify by asset class (holding bonds as well as stock and cash is a good start). If you have an individual holding that is more than 5% of your portfolio you should look at the security risk and decide whether cutting back on the security might be prudent. (I make an exception if it is a government bond).

Measuring Risk: The simple measure is a personal measure you should make much of my hard saved investment portfolio will I put into the equity or high risk security markets this year knowing I can lose most of it if the market tanks.

Once that measure is clear, you might get a little more technical since we started this blog by discussing the fact that investment risk is a mathematical concept.


SHARPE RATIO: A common method of measuring investment risk is to measure the investment returns on a specific security or fund, relative to the risk of owning the security/fund.( risk here is defined as the standard deviation of returns). In short; how much did I gain relative to the risk I have taken? This is generally expressed as a ratio known as the "Sharpe Ratio". Many securities firms show a "sharpe ratio" when you check the portfolio performance of a fund or portfolio.

Concept: You should not compare returns of Fund A versus Fund B unless you know the risk each fund carries. Comparing the Sharpe Ratio allows you to determine if the actual returns on a fund or portfolio are likely due to better portfolio management or just bigger risk taking that happen to paid off in the period you are looking at. In short, when it comes to the Sharpe Ratio, bigger is better as you are measuring returns for a common measure of risk.

Sortino Ratio: The Sortino ratio is a modification on the Sharpe ratio. It correctly presumes investors are worried about downside risk not upside risk. As such it measures the return of a security against the standard of deviation of negative price moves only. If a security tends to have sharp upward price moves and fewer large negative moves, then investors are likely to benefit from the positive volatility. Similar to Sharpe, bigger is better.

The purpose of this blog is to have investors take ownership of their personal "risk" tolerance. To do so you need to understand what your advisor/salesperson is talking about when they mention risk. Many supposedly qualified advisor/salespersons have talked about their clients reassessing the risk tolerance they have. The suggestion is that "clients overestimated their risk tolerance". Nothing could be further from the truth. Your risk tolerance does not change based upon portfolio performance because it is hard wired into your personality. If I had told you the amount of money you were going to lose before the market dropped you would likely have said "no way" because your salesperson/advisor would not leave you exposed to that size of a loss. You likely never understood the risk profile of your portfolio and your salesperson knew that. They understated the market risk you were exposed to and now they are pointing the finger of blame on you for not realizing you should never have trusted their rosy forecast to begin with. They knew that losses were emotionally devastating because they studied the Prospect Theory. Unfortunately they were motivated by the Modern Commission Theory and you were the ticket to their big commission.

Fool us once, shame on the salesperson.....fool us twice.......


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