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As I mentioned yesterday, investment risk is often measured against the investments themselves, and for good reason. Too often, though, these measures don’t really capture the risk that individual investors face.
Today, we’ll talk about what risk really is, in an individual context, and start to think about what that means for measuring risk and constructing portfolios to avoid it.
Defining risk
At the end of the day, risk means the possibility of failing in your objective. Any measure of risk that doesn’t explicitly take that into account isn’t very useful.
Average returns are helpful in that they tell you whether, on average, you will meet your goal, but they say nothing about whether that average will be attained. If your goals depend on getting average returns, then, by definition, you’ll fail half the time.
Looking at minimum returns over a given time period is a useful step, in that you can make a more meaningful comparison between your goals and the worst-case results, but they’re not a cure-all.
Two ways a portfolio can fail
To really understand risk, we first need to understand the different ways a portfolio can fail. I would argue that there are two principal failure modes in investing, which I call slow failure and fast failure.
Slow failure relates to insufficient returns over time—i.e., a portfolio that simply will not generate the expected returns needed to meet goals. My post the other day, in which I noted that returns over the next 10 years are unlikely to match investor expectations, offers an example of how slow failure can play out. If you expect and need returns of 8 percent, and you get 6 percent, you ultimately won’t have enough money.
Fast failure, on the other hand, can best be described as an unexpected drawdown, such as what we saw in 2000 or 2008. For investors who aren’t prepared, these drawdowns can destroy their ability to achieve their goals. For a retiree who lost 30 percent of his portfolio in 2008, for example, that 7-percent nut I discussed the other day now becomes a 10-percent nut, unless the investor decides to either take less income or start spending down the capital. Either way, the plan has failed.
Traditional investment theory can be understood as an attempt to balance these two failure modes. Avoiding the slow failure risk of low returns requires us to maintain high levels of exposure to higher-return assets (i.e., stocks), which then exposes us to greater risk of fast failure, or drawdown.
Diversification is an attempt to spread out the risk of fast failure, while minimizing the chance of slow failure.
In my view, a goal-oriented risk analysis—one focused on the real risks that can make us fail—provides better guidance for the individual investor. Tomorrow, we’ll discuss how to apply these risk ideas in portfolio planning.
