We live in a risky world. Those risks loom even larger for the sizeable population of baby boomers reaching retirement age in an environment of low interest rates and uncertain financial markets. Managing risk lies not in the realm of the theoretical, but in the realm of the practical, for those investors, and, indeed, for all investors who desire to preserve and grow their wealth over time.

In the latter half of the 20th century, investment risk was thought to be well understood: modern portfolio theory proved an investor could maximise return for any desired level of risk, or minimise risk for any desired level of return, simply by optimising return forecasts, the volatility of those returns and the correlations between asset classes. The first decade of the 21st century reminded us that investment risk was far from completely understood. Returns were volatile and unpredictable, price bubbles inflated and burst, financial crises spread around the world, and correlations rose precisely when the benefits of diversification were most needed. How, then, should investors think about risk today?

The first principle of risk management is to define risk, and that definition may vary from investor to investor. Modern portfolio theory holds that risk is equivalent to price volatility, but most investors define risk more viscerally as the possibility that they might lose their money and not get it back. In a broad sense, an investment portfolio represents future spending, or the ability to leave money to the next generation or to philanthropic causes. The permanent loss of capital implies some of that future spending won’t be able to take place. Investors should think long and hard about what they need their investment portfolio to do for them and invest accordingly. The implication of this is that risk is an idiosyncratic thing. Just as the future spending and philanthropic desires of an investor vary, and even change over time, so engaged advisors will continuously work with their clients to understand that shifting definition of risk and invest accordingly.

[I]nvestors who are interested in protecting and growing their wealth over time are better off focusing on value, which has the opposite attributes of price

Considered investment
Most investors focus on price as the primary variable in making investment decisions. Do I think the stock will go up or down? How far has the stock gone up already? How well has it performed year to date? The temptation to focus on price is strong. After all, price has the appealing attributes of availability, transparency and frequency. We can all agree on the closing price of a stock on any given day, and that price is set continuously on national exchanges. Behavioural psychologists consider this an example of the availability bias, in which we naturally pay more attention and give more credence to information that is readily available.

Yet investors who are interested in protecting and growing their wealth over time are better off focusing on value, which has the opposite attributes of price. The fundamental value of a security is not readily available, and even talented securities analysts can arrive at widely different estimates of value. But value, unlike price, has the advantage of greater stability. The price of companies changes day to day and second to second: value doesn’t. Investors focused on protecting and growing their long-term wealth should therefore be more concerned with value than price.

Various studies have shown that most people spend more time planning a vacation than managing their investment portfolios. Investing requires significant research into the security, enterprise and industry under consideration for a direct investment, not in an effort to confirm opinions already held, but to understand how those opinions might be proven wrong. Even if an investor engages a professional advisor, they should still take the time to understand what he owns, why he owns it, and how it aligns with his own definition of investment success. Knowing what you own is a critical element in identifying and managing portfolio risk, as it allows investors to differentiate between factors that can change the long-term value of an investment, and those that simply affect the short-term price. There are two basic implications of this principle. First, it is dangerous to invest in securities or portfolios where you don’t have visibility into the investment rationale, process or holdings. Transparency is critically important. Second, holding too many positions can prevent an investor from knowing them well enough. Diversification certainly plays a role in portfolio construction, but too much diversification leads to shallow knowledge of each investment.

Confronted with the burden of such in-depth research, many investors choose to manage risk by only owning passive investments, such as index funds, that mirror the return of a broad range of securities. Yet passive investing has not proven to be a good hedge against loss of capital, and, in a very real sense, there is no such thing as passive investing. Investors in an S&P 500 Index fund lost 50 percent or more of their money twice since the turn of the century. The market bounced back in both cases, but surviving a bear market in anticipation of a rebound to follow requires the fortitude to remain fully invested – a difficult thing to accomplish when human nature wants to just stop the losses and sell everything. Both of those bear markets remind us that indices, by virtue of their construction methodology, are essentially price momentum strategies. The larger a company is (price per share times number of shares outstanding), the more of it an index fund has to buy. That, in turn, creates upward price pressure that increases the market cap of the company, requiring even more purchases. That momentum shifts into reverse in a bear market. Instead of thinking of investing along an axis of passive versus active approaches, investors should consider the underlying strategy at work – even if unintentional – and decide on that basis.

Managing risk
Since the ultimate objective of portfolio construction is to support future spending, investors should appreciate that there is a difference between wealth and money: purchasing power. While this simple fact may not be top of mind during times of modest inflation, for those investing for the long term, inflation is an on-going threat to preserving and growing wealth. Ultimately, it is not how much money you have that counts, but what goods and services that money can acquire. Inflation – even at modest levels – eats away at that purchasing power every day, posing a risk that traditional methods of risk management can’t hedge. This seems like a misplaced concern in an environment where inflation is subdued, but that won’t always be the case, and, even if it is, the damage that inflation can wreak on the purchasing power of a portfolio over time is meaningful (see Fig. 1). Even at a modest two percent inflation rate, a dollar loses close to 40 percent of its purchasing power over a 25-year period, so longer-term investors should take inflation into account when constructing a portfolio and considering the risks that confront it.

As many of these observations illustrate, diversification is an inadequate tool for managing risk, especially when investors take the time to consider their own definition of risk. Diversification as a means of reducing risk assumes risk is price volatility, and then hinges on the perceived benefit of owning assets that are less than perfectly correlated. If part of your portfolio is headed in one direction while another part is performing differently, the combination can lead to both higher return and lower volatility. This concept makes logical sense, but practically speaking, it doesn’t always ring true. Indeed, experience has shown that correlations between asset classes rise in periods of stress, therefore diminishing the benefit of diversification precisely when it is most needed. Furthermore, the interconnectedness of economies and financial markets has generally caused correlations to rise over time. Diversification is not without merit, but it is insufficient alone as a tool to manage risk during financial crises.

Investment success is a marathon, not a sprint, and as global financial markets change in the 21st century, so too must our understanding and management of the risk that necessarily accompanies any investment activity. Rather than accept a market definition of risk, it pays for an investor to think long and hard about what they want their portfolio to do for them, and what risks threaten the successful accomplishment of that goal. That is a time-consuming exercise that warrants regular revisiting. Nevertheless, the payoff for that investment of time and energy is a portfolio better aligned with the investor’s objectives, and a more robust relationship with an advisor who is helping the investor to attain those ultimate goals.