“Life is a voyage in which we choose neither vessel nor weather, but much can be done in the management of the sails and the guidance of the helm.” - Author Unknown
Over the past six weeks we’ve been exploring the topic of risk as it pertains to our finances. Risk is an ever-present part of life, yet most people turn a blind eye to the risks they are either intentionally or unintentionally taking. In its simplest form, risk is the chance of losing something of value. Since we value a wide variety of things in life (financial security, health, relationships, happiness, etc), managing the risk of losing any and all the things we value can be a tricky proposition. We add risk to our lives not only through the actions we take, but also through inaction by putting off important decisions that can highly impact our lives or the lives of those around us. Over the past six weeks we have tried to define risk as it pertains to finances and identify some of the larger financial risks in people’s lives. In today’s post, we will recap some of the key takeaways from our series on financial risk.
The academic definition of “risk,” as it pertains to investing, is the volatility of returns. In other words, an investment that zigs and zags all over the place is more risky than one that is more slow and steady with less variation in returns. Although this definition of risk is true to an extent (especially when factoring in the human element of making poor investment decisions based on emotions at inopportune times), it still falls significantly short of encompassing the definition of investment risk.
Boiling risk down to the volatility or standard deviation of returns, makes the huge assumption that investment returns are normally distributed, which means the probability and magnitude of a negative surprise are equal to that of a positive surprise. This is in direct contrast to the old Wall Street adage which goes something like, “the bull climbs the stairs while the bear jumps out the window.” In other words, stocks slowly grind higher (little upside risk) but drop precipitously (large downside risk). This is why it is important to consider not only the variability of an investment's historical returns, but also how much of that variability is skewed to the downside versus the upside. This is why we work to build truly diversified portfolios with low correlated investments that don’t all zig and zag in unison so that the end result is a portfolio with less downside risk and more positive skew.
Even the best constructed portfolios can still fall prey to the cost of being human. As human beings, we like to think of ourselves as rational beings that are good at making decisions, but when it comes to investing, the evidence points to the contrary. The problem lies in the fact that all of us live in the present and are constantly bombarded with information that affects our decision making. Often times this information is more noise than useful information, but it evokes an emotional response which can lead to irrational decision making with dire long-term consequences. As Greg Davies of Barclays Capital noted:
None of us lives in the long term. We all, to our perpetual discomfort, live in the present, in what we call the zone of anxiety where we are always buffeted – financial and emotionally – by short-term uncertainty.
The best way to address the risk of human emotions in decision making is to account for them in the investment process rather than trying to stifle them and pretend like they don’t exist. This again is why we build portfolios that are truly diversified (Diversification 2.0) with a quantitative risk management program (MarketVANE) in place, because we know the risk of being human is real and we believe this type of investment approach provides our clients with the best chance of reaching their financial goals.
Before we can invest, we must know how to plan for our financial future. This means we have to address the risk of not thinking long-term by spending rather than saving our money and not having protection in place to insure against catastrophic events such as death or disability. Planning risks are generally risks of omission because they usually involve delaying tough or burdensome decisions. One of such decisions, saving for the future, we have written about at length in the past, so we won’t belabor the point too much in today’s post. The key takeaway for why everyone should budget and save is that we all want to be Elliott’s rather than David’s and harness the miracle of compound interest.
Along these same lines, it is important to understand covert spending in the form of hidden fees and expenses, which acts as a headwind to compounding growth in our investments. There are many layers to the fees and expenses people pay to invest their money including, but not limited to, management fees being charged by financial advisors or insurance companies, plan and oversight fees in a retirement plan such as a 401k, or expense ratios being charged to mutual fund investors. As we pointed out in our post on this subject, there are two camps when it comes to fees which are diametrically opposed to each other. Our belief lies somewhere in the middle where fees should be reduced whenever possible and higher fees should only be paid on investments that offer a meaningful amount of differentiation and diversification from their lower cost, passively indexed brethren.
In addition to squirreling away adequate savings for retirement and keeping an eye on the different layers of fees and expenses, we must also plan for the unfortunate and morbid possibility of our own death. The risk of inadequately planning for the end is a risk that we pass on to the loved ones who survive us. Taking the time to plan for such an unfortunate event by having a properly executed will or estate plan in place with adequate levels of life and disability insurance, ensures that the emotional burden of dealing with the loss of a loved one doesn’t have to be compounded by a financial burden.
Hopefully this series on risk has given our clients and readers an expanded view of the risks they are taking with their finances. Risk is an ever-present part of nearly every area of our lives. As investment professionals we understand that it’s part of the equation that cannot be eliminated, so we do our best to understand and manage it whenever possible. As the unknown author of the opening quote aptly stated, “life is a voyage in which we choose neither vessel nor weather, but much can be done in the management of the sails and the guidance of the helm.” We couldn’t agree more.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.