10 thoughts on risk

Thinking about risk in investment strategy means going beyond the simplistic notions of risk attitude questionnaires.

1. Risk is not the same as volatility

The financial adviser profession has learned the lingo of financial economics. Modern portfolio theory, Sharpe ratio, mean-variance optimisation, efficient frontier. And so on. But do they understand what it really means or how it should be applied to individual financial planning? Excessive focus on the risks in an individual’s asset portfolio, measured by volatility, is at the heart of what Nobel Laureate Robert C Merton has called ‘the crisis in retirement planning’.

There are relatively few situations where the one year volatility of your portfolio or the Sharpe ratio is a relevant measure of risk or return. Yet this is where risk attitude questionnaires focus. Instead, risk needs to be measured as the probability and extent to which you may not attain your financial goals. This almost entirely arises from the extent to which your assets and expenditure needs are mismatched. Merton illustrates how an inflation-linked bond portfolio can perfectly match your goals and yet be very volatile in its value year on year. The risk is zero, but the volatility is not.

2. Manage risk by being flexible in your goals

Much discussion about risk focusses on asset allocation. Rightly so, it’s important. But underestimated is the importance of flexibility in your goals. If risk in personal finance arises from the mismatch between your assets and expenditure needs, then you can close the gap from both sides.

Many problems in finance arise from the attempt to meet fixed expenditure goals with risky asset portfolios. This leads to problems like ‘sequence of returns risk’ in retirement. But if we can be flexible in our future expenditure, aligning it with the risk inherent in our asset returns, then this self-inflicted risk goes away.

3. Don’t ignore non-financial assets and risks

This, of course, means protecting your human capital (your future earnings) through appropriate insurance. But it also means being aware of your human capital as part of your total portfolio of assets. If you have high human capital, at the start of a high earning professional career, then you can afford to take more risk in your investments, through higher stock market exposure, for example. Other assets also matter to a life well lived. Your health, relationships, sense of community. These require investments too, of time and good habits.

Non-financial risks don’t just relate to your livelihood. Operational risks can cause platforms to fail — do you have alternative sources of money to cover short-term outages? And if fraud or incompetence at one provider led to your investments being lost or impaired, where would you be left?

4. There’s no such thing as a free lunch (but overpriced ones are a thing)

If something seems too good to be true, it probably is. For most people it’s impossible (legally) to increase expected portfolio returns without taking more risk. If anyone tells you otherwise, look for what they’ve missed (or hidden).

However, it’s perfectly possible to overpay for your returns through the risks you take. Examples include failing to diversify properly, or incurring self-inflicted risks that aren’t rewarded by the market, like sequence of returns risk. So make sure you’re only taking the risks you need to, to get the returns you want.

5. Misjudging risk is a risk

We’re just not very good at judging risk. The human mind is drawn to causal explanations. Stories provide meaning. Probabilistic thinking doesn’t come naturally. As Daniel Kahneman puts it in his classic Thinking Fast And Slow , ‘causes trump statistics’. This can cause us to ignore realistic probabilities and focus instead on vivid but rare events. Hence we fear terrorist attacks more than car accidents, despite the latter being a much greater threat to us. On the other hand, when they aren’t vivid, rare events tend to be ignored.

So we either think that rare events are far more or far less likely than they are. But we rarely get it right. So we might overestimate the probability of getting wiped out by a stock market crash. We have recent experience of market volatility, the news is full of daily price movements. But we might underestimate the probability of the less salient, slow motion train wreck of our finances being over-run by living far too long.

What can we do about it? Be aware and do anything we can to tame our intuition by bringing objectivity, data, and structured decision making processes to improve our estimates.

6. The worst risks are often things that haven’t happened before

Studying history is useful. But as the old saying goes, it doesn’t repeat, it rhymes. And maybe not even that. 150 years of investment data sounds a lot, but is equivalent to just a handful of completely independent, non-overlapping investing lifetimes. Not a big sample. So we can’t just go on what has or has not happened in the past. And we shouldn’t be surprised if investments that protect us against risk seem to charge more for that insurance than historical analysis would suggest. That’s because the insurance doesn’t only protect us against what has happened before, but what might have, or might yet.

Safe withdrawal rates in retirement income planning are a great example of this. They can make annuities seem expensive. But that’s because analysis based on history ignores the full range of risks that annuities protect against.

7. How risks can be like buses

Correlation is one of the most important concepts in risk management. Low correlation between assets is the basis of diversification: if one is getting hammered, the other isn’t. But correlations sometimes break down when you most want them not to. For example, it’s known that corporate bonds and equities are diversified in positive times, but when markets tank, corporate bonds become equity like and lose their diversifying properties.

Other risks, like buses, can come along in threes. The recession that causes you to be eased out of the partnership may be the same one that causes your buy-to-let portfolio to be underwater and the same one that causes the tide to go out on the peer-to-peer lending platform that offered such juicy returns.

8. Beware of picking up pennies in front of a steamroller

There are lots of ways to make a little money most of the time in exchange for the risk of losing lots of money rarely. Strangely, some of them are sold as risk management techniques. Portfolio rebalancing is one such. Suppose your financial adviser suggested making some extra money by writing a straddle option on the difference between equity and bond returns, which results in unlimited potential future exposure in exchange for a fee today. A good idea? I thought not.

But this is all that rebalancing is. Evidence suggests that when equity and bond returns stay within a range of about 5%–6% pa growth of each other (i.e. some degree of mean reversion) then rebalancing creates a premium of around 0% to 1% a year. But the cost is much larger losses, which are, in principle, unbounded but in practice around 2% to 3% a year, when one asset class vastly outperforms another over a sustained period. This can mean losing out on the upside in a bull market like the 1980s. Or it can mean rebalancing into the teeth of an equity bear market like Japan in the 1990s. This matters less in the accumulation stage, but can be devastating in retirement. Indeed, rebalancing at the start of retirement just adds to the sequence of returns risk introduced unnecessarily by common retirement withdrawal strategies.

By all means take active bets to create higher returns. But be clear what you’re doing and be careful about bets where the probability of losing is low, but the cost high.

9. You’re your own worst enemy

We’ve not evolved to deal with the risks inherent in an investment strategy. As a result, we suffer from countless biases that undermine our financial health. Myopia, excessive risk aversion, overconfidence bias, probability neglect, availability bias, narrow framing, anchoring. And so on. As a result, one of the greatest threats to our financial wellbeing is our own behaviour. We take our selves wherever we go so what can we do about this? The first thing is to be aware of the unreliability of our minds in this area. And there are strategies to overcome our biases involving structured approaches, widening our frame, appropriate data and analysis. Kahneman’s book Thinking Fast And Slow is a great starting point for self-education.

But we also need to acknowledge our psychological weaknesses in how we develop an investment strategy. For example, mental accounting is a pervasive if illogical bias. But if bucketing helps you to stick the course in your strategy then embrace it. A plan is only a good plan if you can stick to it. Another behavioural risk we need to be aware of is cognitive decline. It’s well established that performance in financial decision making declines over time from your mid-fifties. Don’t have an investment strategy that requires complex decision making in your eighties (or appoint an adviser you trust to decide for you). You need to protect yourself from yourself.

10. The risk of driving yourself crazy

But where do we stop? What is the boundary of the unknown unknowns that we need to protect against? We do have our assets spread across two platforms because it’s easy and cheap to protect against the realistic possibility of fraud or bankruptcy causing a problem with one of them. But we don’t have a stone cottage in the Scottish Highlands with guns and gold buried. I’m assuming the UK government probably won’t default (although I wouldn’t put all my eggs in that basket). We’re betting against meltdown of society or the financial system, if only because I wouldn’t know how to protect against it.

We need to judge for ourselves the risks we’re prepared to bear and the ones we protect against. But at some point we have to say: enough is enough. For our own sanity, some bridges are best crossed when you come to them.