Do you remember what risk feels like? While the market has wobbled during the current bull run, the ride has generally been smooth: stock market volatility has been trending below its long-term average for 68 months. This marks the third-longest stretch of below-average volatility for the index dating back to 1939. The next longest period lasted 75 months, from March 1956 through May 1962. So, the current streak is unprecedented in the experience of most investors.
The most common definitions of investment risk are rooted in uncertainty. How likely is it that the returns on an investment will deviate from the expected returns, and by how much?
Real risk lies in how we respond to the ups and downs in the market. The volatility that we try to capture in data is the net result of the actions of flesh-and-blood human beings. We are all responding to signals from our environment and one another. These signals are being generated and interpreted by a hunk of grey matter that is wired for survival. We are risk-averse beings by nature. The real risk is that we do the wrong thing at the wrong time and put ourselves off the course toward reaching our goals. It’s impossible to convey that with data.
Risk is Personal
This concept of risk is absurd to measure because it is deeply personal. How investors experience and respond to risk will vary depending on personality, circumstances, and experience. Investors’ risk appetite may fluctuate with the market. It might also change with time.
Investors’ risk tolerance is driven in part by personality. Some people are wired to seek out risk, be it in the markets or by jumping out of an airplane. Others much prefer to play it safe, with their feet firmly on the ground. Risk is personal.
Of course, investors’ circumstances also affect their willingness and ability to take risk. Investors who have accumulated substantial financial assets likely have a greater ability to take risk, but they may wish to preserve their capital and, thus, be less willing to assume more risk. Investors’ ability to take risk is also time-horizon dependent.
Recent graduates have ample ability to take chances, for example, given that they likely have decades to save and invest before they retire. Investors nearing retirement may have relatively less ability to take risk as they transition from accumulating financial assets to relying on them for retirement spending. None of these considerations is captured in standard risk measures.
Investors’ experience will also influence their relationship with risk. People who have lost vast sums in the market in the past may be uneasy about taking risk in the future. Serial entrepreneurs may be more comfortable with risk than company men and women.
Attitudes about risk will also shift with the markets and evolve over time. It's easier in a bull market to feel comfortable about taking on risk.
How to Manage Risk
There are three main ways to manage investment risk: asset allocation, investment selection, and behaviour. Ideally, the first two should optimise for the third. Perhaps the most effective way of managing risk is to select an appropriate mix of assets. Investors with a higher threshold for pain should favour equities. Those who are more squeamish should lean toward bonds and cash. Striking an appropriate balance is tricky. Just because an investor doesn’t like the ups and downs of the stock market doesn’t mean that she can afford to stay in cash if she wants to meet her goals.
At this point in the market cycle, it makes sense to revisit asset allocation. Given shares’ relative performance over recent years, odds are that many investors are heavy on shares and light on bonds. If this is the case, it may be time to rebalance back to a more appropriate mix. The right combination will ultimately depend on many of the circumstances described above.
Investment selection is another lever that investors can pull to ratchet their risk. Large-caps are generally going to be less risky than small caps. Developed world shares will be less volatile than emerging markets ones. Government bonds are safer than corporate bonds.
Finally, one of the most important sources of risk is the one we look at in the mirror each day. Poor decisions regarding asset allocation and/or investment selection can easily put us off course. As such, the choices made regarding the first two buckets should optimise for behaviour. The best portfolio is the one you’re most likely to stick with the next time things get hairy in the markets. Trying to solve for this is the best way to manage the biggest risk of all.