What Exactly Is Risk: Part II

Summary

• The expected return of a portfolio should never be considered as a single point, but instead, should be considered as a potential distribution of outcomes.
• Tracking error, black swan and maverick risk are a few other ways to define the risk that investors and advisors face.
• Standard deviation isn't the only risk investors and advisors should consider when developing a financial plan and investment policy statement.

Today concludes our two-part feature that aims to define risk. Not being able to do so is a problem for both advisors and investors.

Alternative Definition of Risk

Risk can also be defined as the probability of not achieving your financial objective - with the objective generally being not the accumulation of the greatest wealth, but instead, having sufficient wealth to allow for the maintenance of an acceptable lifestyle (and not run out of funds while still alive). It's important to note that the expected return of a portfolio should never be considered as a single point, but instead, should be considered as a potential distribution of outcomes. The use of a Monte Carlo Simulator can help with estimating the risks (odds) of failure.

Tracking Error

Another type of risk, one that is purely psychological, though real nonetheless, is what is known as tracking error risk. For example, U.S. investors that build globally diversified portfolios will experience investment results that are quite different than those experienced by the "market" - with the market defined as a broad major index such as the S&P 500. Some years (i.e., 2000-03), investors will like the divergence, as the tracking error is positive. Other years, they may be unhappy with the divergence (1998-99), as the tracking error is negative. Negative tracking error can lead to loss of discipline. Thus, investors that are sensitive to the risk of tracking error should consider either minimizing it or avoiding it altogether.

Black Swan

Another risk that should be carefully considered is that of the unexpected negative surprise - the appearance of the so-called "black swan." Unfortunately, one of the most common and costly mistakes made by investors/advisors is to treat both the highly unlikely as impossible and the highly likely as certain. Prudent investors know that history teaches us that just because something hasn't yet occurred doesn't mean that it cannot, or will not, occur in the future. One has to look no further than to the events of September 11, 2001 for proof of this important point. The potential for negative surprises should be built into any investment plan. Forewarned is forearmed.

Maverick Risk

There is yet another risk investors/advisors must deal with - maverick risk. As Robert Arnott points out, "practitioners 'know' that the greatest peril is the risk of being wrong and alone. As such, we fall prey to the Keynesian dictum that it is more acceptable to fail conventionally than to succeed unconventionally. Decisions that leave an investor alone carry the inherent risk of being both wrong and alone. If an investor is wrong and alone, a strong likelihood is that the assets' owner will not have the patience to see the investment decision through. The decision, even if correct in the long run, will be reversed before it can succeed."¹

We are all familiar with the expression "misery loves company." Experiencing relatively low (but still positive) investment results may create more psychological risks to the investment plan being abandoned than experiencing losses if everyone around is having a similar experience.

Confusing Strategy and Outcome

Another psychological risk is the confusion of strategy and outcome. Investors/advisors often judge the correctness of a strategy by the outcome. This is both a common and huge mistake. In a world of unclear crystal balls, either a strategy is correct before the fact, or it isn't. Consider the case of a family breadwinner with a spouse and children to support. Unless the family is independently wealthy, life insurance is almost always a part of a prudent financial plan. Yet, we don't judge the correctness of the decision to buy life insurance by whether or not the beneficiary collected on the policy. Purchasing insurance is either right ex-ante or it is wrong ex-ante. The same must be true of investment strategies. Nassim Nicholas Taleb put it this way: "One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).² Like with other risks, confusing strategy and outcome can lead to the abandonment of a well-thought-out plan.

Honesty

Finally, there is one other risk that investment advisors face. That risk is to tell people what they don't want to hear. I good example is: "We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either. However, we can design a portfolio that will give you a reasonable chance of achieving your financial goals given your current and desired lifestyle." A good advisor is one that delivers the message, regardless of whether or not the client wants to hear it. While it may, in the short run, result in a loss of business, in the long run, this isn't likely to prove to be the case. And, at any rate, integrity is its own reward.

While standard deviation is one important measure of risk, it's certainly not the only one investors and advisors should consider when developing a financial plan and investment policy statement. The prudent investor considers all of the risks of investing (be they real or psychological) when developing his/her plan

1. Robert D. Arnott, What Risk Matters? A Call for Papers! Financial Analysts Journal, May/June 2003.
2. Nassim Nicholas Taleb, Fooled by Randomness.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.