It’s impossible to talk about any element of investing without eventually discussing risk. It’s as fundamental to investing as calories are to food. Unfortunately, most conversations about risk miss the mark.
How risky is your portfolio? It’s a good question, but can you get a good answer?
The financial services industry, I would argue, does a terrible job of communicating risk to individual investors. More often than not, analysts go straight to the numbers to quantify the risk level of a security or portfolio.
Standard deviation is the magic number for risk. It measures how much returns vary from year to year. Do returns jump around from year to year, or do they always come in near the average? More variation means a higher standard deviation, which means more risk.
Standard deviation is a great statistic. However, if you’re a normal person with a career and a family and a dog or a cat, it means almost nothing.
I’m all for using data to answer questions. But unless you have an unusual affinity for statistics, calculating risk as standard deviation won’t be of much use to you.
For instance, if I tell you the standard deviation for a particular mutual fund is 5 percent, does that mean it’s risky or safe? For most people, it means neither; it’s just a number that says nothing at all.
I advocate a completely different approach to talking about risk.
I propose that when you think about risk, you are really thinking about the bad things that would happen if you didn’t meet your goals. In investing, you’re thinking of the risk of financial distress for you or your family if things don’t go well.
Ultimately, risk boils down to one monumental make-or-break question: Will I run out of money late in life?
If we look at risk from this perspective – the possibility of running out of money someday or having to drastically reduce your standard of living – it completely changes the discussion.
Whereas a statistic like standard deviation means almost nothing in personal terms, the idea of relying solely on a small Social Security check to survive is supremely personal. Running out of money presents real, unavoidable implications about how you will secure housing, food, healthcare and other necessities of life.
This perspective on risk is about the investor – not about the stock, bond or portfolio. As a spouse, parent or grandparent, you surely don’t care about the prospects for a certain mutual fund. But you care immensely about maintaining your own financial independence and protecting the financial future of your family.
My goal in talking about risk is to help clients understand their exposure to the worst-case scenario of running out of money, as well as other financial fears they may have. I discuss how spending and investing decisions increase or decrease that exposure.
I often have to run some quantitative models to do this, but the numbers are there for reference, not as the primary subject of the conversation.
If you work with a wealth advisor, be sure when the topic of risk comes up that the conversation focuses on your risk, not solely on statistical measures related to your holdings. The discussion should be goal focused, not market focused.
While we were in the NICU, the doctors sometimes would turn to numbers to discuss options and risks. A treatment option was historically effective for about 70 percent of patients. A medicine had a 60 percent success rate.
I absorbed these numbers but couldn’t translate them into anything very useful. Even when I learned that babies born at 25 weeks had a 50 to 80 percent chance of survival, the 20 to 50 percent chance of failure seemed overwhelmingly high, knowing failure meant death. I simply could not connect the numbers to anything I understood.
I see now why presenting investment risk in numerical terms is so unhelpful for many investors: When you’re dealing with gut-level fears, numbers don’t mean much. Anything less than 100 percent certainty of success sounds like a huge risk.
Too safe can be risky too
Investors sometimes ask for portfolios with “as little risk as possible.” This sounds prudent, but it can be a terrible idea. A portfolio with extremely low risk means a portfolio with extremely low expected return. Think of a passbook savings account.
Without accepting some risk, a super-cautious investor is likely to earn so little in return that he or she will not even keep up with inflation. Every year, his or her portfolio has less, not more, purchasing power.
My colleague Larry Swedroe has written in his many books that your risk level should depend on your ability, willingness and need to take risk. Your discussion of risk with an advisor should include all three.