The Independent Market Observer

1/17/14 – Risk and Expectations: Driving Fast Vs. Getting There

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 17, 2014 9:07:27 AM

and tagged Economics Lessons

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The Yogi Berra post I did a couple of days ago drew a distinction between steady single investments and home-run investments. Baseball is a popular metaphor for a number of things, but, given the intersection of statistics and uncertainty, it’s particularly relevant for investing. Michael Lewis, for example, is noted for writing about both Wall Street (Liar’s Poker) and baseball (Moneyball). Nate Silver, the former New York Times political statistician, has made ventures into both finance and baseball.

A key to success in each of these areas is to determine which numbers actually matter. This is one of the issues at the core of Moneyball. I would argue that we have the same problem in investing, particularly for individual investors. We’re simply looking at the wrong things.

Modern financial theory was developed to be mathematically tractable. Because of that, simplifying assumptions were made, and analytical methods used, which were limited by what could actually be done to justify them. Even so, these methods work well when the assumptions are close to reality. Problems arise when they’re not.

As an example, let’s take a couple of the most egregious assumptions, in my opinion—rational actors and the variability of returns as a measure of risk. At the institutional investment level, these aren’t bad approximations. Large teams of investment managers, who aren’t managing their own money and have a long time frame, can afford to take a dispassionate, rational attitude to money management. As they manage against expectations with a long horizon, the variance between what’s expected and what happens is a reasonable measure of risk.

At the individual level, however, neither of those assumptions applies. I am considerably less rational, for example, about my own investments (especially when they go down) than I am in advising others. It just hurts more when it’s mine. Similarly, given my own shorter time frames and lower asset levels, I feel the downturns much more than the variability.

Because of this difference in focus, time frame, and pain level, the two usual measures for investment results—return and risk, expressed as variance—do a poor job of reflecting most individuals’ ability to manage their own investments. While I may know the right answer intellectually, in the long run, I may simply find it impossible to do it. Knowing the right answer is useless if I can’t act on it.

We actually see this in investment results. Mutual funds with more volatile returns have had lower realized investor returns than those with smoother returns. This suggests that volatility is, in fact, the right measure—but what shakes people out is not volatility, but losses. Volatile gains seem to be okay, which makes intuitive sense. It’s not the volatility, it’s the loss.

My own research has for some time focused on redefining risk around loss avoidance. In other words, I’m fine with volatility as such, with returns bouncing around, but how can we construct portfolios so as to avoid large losses? By turning the emphasis from generating returns (and worrying about how much they vary) over to minimizing drawdown risk (and then seeing how much return can be generated, under that constraint), I believe we can better maximize the returns that individual investors actually get.

To use another metaphor, consider driving. For professional investors, like professional racecar drivers, the goal is to finish the race and the season fastest and with the highest score. There may be problems, even crashes, along the way, but that’s an accepted part of the game.

Compare this to a family driving to a vacation. As much as you may want to get there fast, to get the screaming kids out of the back seat, the ultimate priority is not speed but arrival. A crash will change all of your lives in ways that no one wants to think about. You are more concerned about getting there safely than you are about clocking the fastest time.

What we need, ultimately, are Volvo portfolios, not Porsches—or at least the possibility of Volvo portfolios. This has started to happen post-2008, but I still believe we can do better. I’m currently working on a paper that looks at ways to accomplish this, and have had very encouraging results so far.

Of course, once that goal is achieved, the next problem becomes wanting Porsche performance with Volvo safety—which is a matter of expectations, to be discussed next week.

Have a great long weekend!

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