We recently wrote about a benign self-delusion as it relates to investment decision making. We were talking about the illusion of control. You want to see illusions play out? Look at the average person’s, (even the average professional investor or investment advisor’s) ideas about risk and risk control.

The problem is that the standard mechanisms of evaluating risk have generally worked (within the context for which they were designed), and thus nobody sees any reason to really change them. In fact the various regulators and influencers within the industry certainly view the use of traditional risk measurement systems as best practices, and encourage, or enforce their use, and this has generally been beneficial to investors. (Authors note: A notable exception to this is the cVar debacle in 2008, which has been written about extensively, but this was more a problem of crowd thinking than a fundamental flaw in the theory. It was mostly an example of not thinking the problem through to its conclusion. I will probably do a quick post on this later. If you don’t know anything about it, there is a fair amount of work already out there on it. The Economist has a good piece on it HERE.)

It is certainly true that advances are constantly made in making them more sophisticated, however none of the advances necessarily make them any more intrinsically valid.   We have very sophisticated ways of measuring very specific risks based on what has happened in the past, or based upon what our expectations are from a statistical or mathematical model. We use standard deviation, and beta and Jensen’s Alpha, and the Sharpe ratio and measures of skewness and kurtosis and hundreds of other mechanisms to try to pin down the answers to questions which are fundamentally very elusive. We are trying to approach the question, “What might happen if…” and all of this data gives us information to make some guess based upon past experience.

There are three very important issues raised in that brief explanation. The first is the idea that we are measuring very narrow, specific things. The second is that all of this information gathered from the measurement of these narrow and specific things is simply measured as part of a mathematical model, which only roughly describes the real world. It relates to the real world the way the set of a movie might. It looks like the real world (maybe) but it has nowhere near the complexity of the original. It is the map of the terrain, rather than the terrain itself. This brings us to the third issue, which is even with good data, and a decent expectation of what has happened in the past as informed by mathematical models which do a good job of representing the world as we have known it, we are still stuck with the problem that the world changes and behaves differently every day. We can only really understand it in hindsight, and then only somewhat. That means we generally measure risks with some degree of hindsight bias, which is a problem in that all of that math makes us sound like we have some kind of fix on the situation. Investors are reassured by the statistics (if you haven’t read it, check our piece on the illusion of control) and advisors generally like it when their clients are feeling nicely reassured. That makes it really easy to leave off the explanations, and not take that extra step which inevitably drags the investor back out of the warm embrace of comfortable faith in the advisors statistics.

The biggest issue is the fundamental disconnect between what people in the industry think of as risk, and what the average person thinks about as risk. By defining risks in a particular way, and by using techniques to limit those risks, as defined, investment professionals of all types can talk about how they manage risk, limit risk and provide “risk-adjusted returns of [insert figure here]” They engage in “smart-beta” strategies and provide “hedged stock portfolios,” and “MVO Optimized portfolios” which all sounds great to the average investor, as it provides the aforementioned illusion of control. Let me stress this here, before we go any further: even if these various techniques work in a certain percentage of cases, or in certain average conditions, they cannot be construed as working absolutely, every time. I am not saying there is anything wrong with these things, just that they are not magic bullets. This slightly embarrassing fact is usually glossed over. If we were to properly couch a hypothetical version of one of these discussions, we might have to say something more like the following, which I will call “Technically correct verbiage on expectations”:

“If the next three years is a repeat of the last three years, and there is no significant catalyst that causes any departure, there is a 65% chance that this portfolio might reasonably return on AVERAGE “a” amount with a high-end expectation of “b” amount and a low-end expectation of “c” amount, which might be about “d” percent of what the S&P 500 did during that time, probably in the same direction.¹ I am about 85% confident of this, but it is based upon historical averages and past performance is no guarantee of future results.”

This is not exactly the kind of commentary that makes an investor feel warm and fuzzy, right?

But rather than doing a treatise on these definitions to start out, let’s take a practical view first. Let’s think about the interaction between an average investor and a hypothetical investment advisor. I grant that lots of other types of professionals use the above terms, and follow the same usages of risk, but we will focus on this one stereotypical interaction to see where the madness begins.   I have witnessed versions of this conversation hundreds of times, and tend to walk away thinking that an opportunity has been wasted, and that a better way to have this conversation must be out there. I also think about the difficulties in getting to that better conversation, which is why I am sitting here and typing today.

Imagine a sitting in the waiting space of a street corner investment office, and hearing the investment representative having this discussion with a potential client:

Investor: “So, if you are managing this portfolio, how much risk would there be?”

Advisor: “Well, we can manage it to whatever risk level you want. We will do a comprehensive risk tolerance analysis, and will come up with something appropriate.”

Investor: “Okay, so what is that like?”

Advisor: “It is a series of questions that have been found to tell us how to position your portfolio in a way that suits how much risk you can handle. We score it and the score drives the portfolio.” (Authors note: this is generally six or eight questions. Hardly definitive.)

Investor: “I just don’t want to take a lot of risk.”

Advisor: “Well, this (hypothetical) portfolio here, on this end of the spectrum, has a standard deviation¹ of 6, compared with the market standard deviation of 15.” (Authors note: these are totally hypothetical figures, for illustration only—the actual discussion of the standard deviation of a portfolio and for “the market” is far more complex than this, although I have rarely heard any such discussion of the intricacies of these differences and limitations when listening to the average investment presentation, which is kind of the point.)

Investor: “Okay…So is that good?”

Advisor: “I think so, in your case. It means that the portfolio is about a third as volatile as the market, so that is a lot less risk.”

Investor: “Okay, that sounds good.”

Advisor: “I think you good even go another rung up the ladder, but we will do the test and see what it says, we will let the science guide us.”

To me, one thing stands out in this discussion. The investor has said they don’t want a lot of risk, and the advisor immediately guides them to a low(er) standard deviation portfolio, and describes it in terms of risk relative to the “stock market,” (presumably the S&P 500^₂ for that period, although it is almost never defined in these talks…) and sort of implies that volatility is equal to risk. Neither “Standard Deviation” nor “Volatility” are actually defined, and if they were, I am not sure that the definition would mean much to the listener. A hundred and one guidelines from every corner of the investment industry make it clear that we need to be telling people about the risk they carry when they make investments. We further need to be explaining to them that investments that offer higher returns have higher risks, which is generally expressed in the same terms as those above. It obviously is important to help people understand their risks, but what if these approaches are flawed to begin with?  What just happened in this hypothetical discussion is a kind of unintentional bait-and-switch. The investor was articulating a desire, and the advisor basically substituted a stand-in feature, which might not really fulfill the desire, but is positioned as if it did. Did this advisor address the client’s stated concern, in real terms? Nope, I don’t think so and I think there are a number of reasons why they didn’t do it, primarily because time and attention are short, but also because as a group, financial advisors don’t really have a good framework for the discussion (it can get complicated, and clients want things to be simple).

Why didn’t the investor stop them? It probably wasn’t apparent that the question was only partially answered, and there are other, equally interesting reasons (one primary reason is that the stuff is complicated, and to most people, really boring). We will be looking into some of the other reasons (on both sides) in another article in the series, but for now I want to stop and evaluate what client was out to discover or inform the advisor about with their comment about risk.

The most common definitions of risk, according to Oxford University Press, on their OED website (http://www.oxforddictionaries.com/us/definition/american_english/risk) are these:

“1. [NOUN]: A situation involving exposure to danger. [1.1] The possibility that something unpleasant or unwelcome will happen. [1.2] A person or thing regarded as likely to turn out well or badly….[1.5] The possibility of a financial loss. ”

When an investor states that they do not want to take risks, I think they mean several things at once, which makes it hard to address. They are thinking of something both far more general and far more specific than the strict interpretation the advisor in the above exchange places on the subject “risk”. They are looking to avoid something unpleasant, and avoid financial danger, and not be exposed to losses.   They are certainly referring to market losses, as opposed to other kinds of risks, but also unpleasantness generally. Here is the beginning of the trouble. A typical investor wants general avoidance of a specific risk—the risk that an investment at some stage loses value.   Good luck with that one. I have not met that particular investment yet. Even “Stable Value” investments and cash holdings have lost value, if you construe value as the ability to buy the same amount of stuff over time. I think the avoidance of general unpleasantness is the bigger driver than the specific desire to avoid market losses. In my experience, and in anecdotal discussions with lots of other advisors over the years, the unspoken intention of the client is to avoid anything that they will feel stupid about later. If their brother in law can look down on them and shake their head sadly over an investment embarrassment, the holidays will become a total grind. Hence, avoiding the “risk” of something bad happening to their investments has a degree of primacy.

What many investors don’t generally see (and in defense of decent advisors, the advisors generally do see) during the above discussion is that there is an entire landscape of “risk” all around the client, which they are wandering through, often blindly. Even the best thought out plan can sometimes lead to a head hanging in shame. It is all about the measurement period. If you invest in the stock market right at the beginning of 1999, and your brother in law is an “I keep my money under the mattress” kind of guy, there were a few awkward holidays during the recession of 2000-2002. However, when 2005 rolled around, the shoe might be on the other foot. The issue is that every decision exposes an investor to something, and any decision can lead to chagrin at some point, depending upon what the comparison period is, and what the point of reference is.

In that risk landscape one might find some of the following potential “unpleasantness” lurking (just to name a few, and there are lots of other possibilites):

1. A major (or even minor) financial crisis in their home country that makes the currency in their pocket worth less quite suddenly, when they try to buy things. Not great when you have all your money in cash, in your native currency, and buy a lot of imports. Particularly a challenge in you live off inexpensive imports to make your standard of living possible.
2. The potential that over time their money does not stretch as far, incrementally year over year, due to the increase in the cost of living, and the potential that they did not keep up with it. Probably a challenge if you earn so little on your accounts that they do not keep up with inflation, and furthermore grow at a rate that allows you to get ahead.
3. The possibility that their “guaranteed income” account or investment does not work out as planned, either from inflation, as in the last example, or for other reasons. This could be a company pension, some kind of insurance product or a federal system. Each of them has ways to fall apart. Really a problem if you have no other savings to rely on.
4. The possibility that medical costs and taxes and other required spending in the future may be way different from what an investor forecasts. Because the future is uncertain (really important word there, which we are coming back to in a bit) there is a risk that future required outlays may not be funded.
5. The challenge that interest rates in new fixed income are lower than what you had when your bond or cd matures, and you can’t get enough income without buying something of lower quality
6. The possibility of a short or long term downturn in stock markets
7. The possibility that the “short-term” instrument that they were going to take money out of suddenly does not have the ability to fund withdrawals. Sometimes this happens. (Anybody remember what happened with certain “floaters” in 2008?)

In short the advisor recognizes that every single decision one makes exposes one to risks. Walk to work? For fun, here are some possible risks:

• Falling bricks from a construction site next door to the office
• Getting to work very sweaty
• Getting bitten by a neighborhood dog.
• Getting hit by a car

Drive to work instead?

• Car accident
• traffic jams
• flat tires
• Wear and tear on car, added expense for parking

There is no risk-free environment. And that is fine with an advisor, because every risk generates a return. Investors want to shun risks, and get returns. Good advisors know that the opposite is always true. Every return that you get implies that some risk is at work behind the scenes. My walk to work improves my cardiovascular fitness in exchange for my risk of showing up in a sheen of perspiration. Maybe my drive to work gets me there a half hour earlier, with time to put the finishing touches on a project.   The risk enables the return. The two are not separable.  The challenge is that despite all of our sophisticated measurements, the actual possibility of one of the unpleasant things happening is virtually impossible to calculate. The benefit of the return from the risk is also pretty hard to calculate in advance, if we mean by it the net effect over time. For example. If I consistently gain a half hour at the office, I may get a promotion, which will compensate me for the gas expended, but then I have to deduct the hypothetical cost of my hypertension drugs, because I never get any exercise. Even with that, things are going swimmingly until I get into a collision with an 18-wheeler on the way home from work. Does that mean I should have been able to predict that my hard work and desire for a promotion would get me crushed by a big truck? The future is unknown and what we can calculate is a tiny fraction of the desired information about what we might be vaguely able to expect. Furthermore, it is also impossible to evaluate the chain of decisions that were not made. You can never quantify what would have happened if I had walked after all, because I didn’t do it, and there are no records. I can go back and say that I would have walked every day, but the first time snow fell, would I have abandoned that commitment and driven after all? No way to know. That is one more reason that measurement is tricky.

So what is the right answer to an investor that does not want something unpleasant to happen? There is seemingly no single correct answer to this. If we go back and look at our “technically correct verbiage on expectations” we remember that it was not what the investor was looking for, and that it felt a little bit like a cop out. The problem is that the more precise, and the more accurate, and the more careful an advisor is, the less inclined an investor is to do something that the advisor thinks is a good idea. The investor wants assurances, and the advisor has learned that assurances get you in lots of trouble in a world where nothing is certain. (I base this statement on the premise that most advisors are fully aware that the future is completely opaque, if your advisor does not believe this, I would run (not walk) to a different advisor. Your advisor is deluded.) We are left with a divide.

We will continue to pursue this issue next time. In the meanwhile, think on this question—is the investor in the above exchange simply asking for reassurance, or are they trying to impart guidance? Do they want to be in control of the amount of risk they take, and if so are they ever really going to be able to exert such control?    Next time we will take up the question of the definition of uncertainty, and compare that to the definition of risk, and see if we can get a little further. After that we will define the “specific investment risks” and see where that takes us.

One way we examine and manage risk is with a personal Investment Policy Statement.  FInd out about one here, or for more information, Download our white paper.

Endnotes
1. S&P 500 is an unmanaged index which cannot be invested into directly.

2. Standard deviation is a historical measure of the variability of returns. If a portfolio has a high standard deviation, its returns have been volatile. A low standard deviation indicates returns have been less volatile