Risk should matter in investing
Dollars & Sense
Q. I took a “risk questionnaire” on a free website recently, and it said I’m a “conservative growth” investor. The site recommends a portfolio of 40 percent bonds and 60 percent stocks. But those returns seem boring, and I want to make more money. How should I think of risk?
A. I’m not really a fan of these simplistic risk questionnaires. They usually ask you about 10 questions about such things as your age, your amount of assets, your views about loss, etc., and pigeonhole you into one of maybe five categories. Then they tell you to buy and hold that category’s recommended asset allocation and accept the ups and downs that come with it. These models and recommendations are based on very long-term historical returns and volatility measurements. If the future looks like the past, and you are able to stick with your plan for decades, it ought to work out. But that’s a lot of ifs and assumptions.
That said, I am a huge fan of managing risk. In fact, the strategy at our firm is all about “risk-adjusted returns.” We accomplish this by managing the mix and increasing risk during uptrends to capture growth but decreasing risk during downtrends to protect from loss. This may be difficult for an individual to do, but the point is to find a fund or manager that specifically manages risk.
Let’s consider how risk affects returns. Let’s say there are two funds, A and B. Let’s say Fund A averages 6 percent returns over 10 years, with the worst year down 5 percent and the best year up 14 percent. Fund B averages 7 percent, but its worst year was down 25 percent, and the best year was up 30 percent. Which fund would you choose? Would the 1 percent better average return of Fund B be enough to tolerate that kind of annual volatility? It wouldn’t be for me. Most investors in Fund B will panic after a year of 25 percent loss and sell at the bottom. This only locks in their loss, and they risk missing out on the subsequent gain. Volatility keeps you from sticking to your plan. And volatility tends to make people lose sleep; never underestimate the value of sleep!
What most investors really want is “asymmetric risk.” That is, they don’t mind risk when markets are rising and they’re capturing gains. But they become very risk averse in declining markets as losses occur. Furthermore, in big market declines and crashes, nearly every asset class becomes correlated (to the downside). Having a diversified portfolio in crashes doesn’t seem to help as much as the models suggest it would. So to sum it up, it’s not enough to take a questionnaire, buy a model portfolio that ought to work, and hope. You need a fund or manager with a strategy that asymmetrically manages risk.
To find such a fund or a manager, you’ll have to do a small bit of homework. You must ask this key question: “What have the returns been annually (monthly is better) for the past five to 10 years?” You need to look at the maximum “draw down” — the maximum amount ever lost, and over a long-enough period, to cover a full market cycle or two. If the maximum draw-down is larger than you can stomach, it’s the wrong fund or manager for you. Since the last market crash in 2008, markets have generally recovered for the past four years. At the moment, with markets making new highs, it’s probably tempting to forget about risk and maximum draw-downs. But just like you plan for a storm when it’s sunny, now is the time to focus on risk-adjusted returns.
Send your questions to email@example.com.
Ryan Investment Management is a Securities and Exchange Commission-registered investment-advisory firm based in Aspen serving individual investors and nonprofits. Its strategy is called “iFolios” — index fund portfolios actively managed for growth and protection. More information is available at http://www.ryaninvest.com or 970-429-1100.
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