That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.
-Warren Buffett

Risk is one of the most challenging concepts to define in investing. There are countless ways to measure it and a myriad of opinions on the proper way to evaluate it. And the debate over risk is not some theoretical academic debate that doesn’t impact everyday investors. Risk can prevent us from achieving our goals. Risk can derail investment plans. Risk can trigger the behavioral issues that we are all prone to. So having a way to properly measure risk is an essential part of any investment plan.

But how do you measure risk?

If you expect me to provide a definitive answer to that, this article will likely be a disappointing one because I don’t think there is an answer, and the right answer can vary for each investor’s situation. But I will try to provide an overall framework to analyze risk and how it impacts investment returns.

Is Volatility Risk?

To illustrate how the definition of risk needs to be looked at situationally, consider the quote from Warren Buffet I led the article with.

In the quote, Buffett contends that volatility is not risk. But is he right? I think the answer to that completely depends on the type of investor you are. For a long-term investor like Buffett who has the patience and means to sit through the toughest, most difficult periods, I think he is 100% correct. In that type of situation, volatility doesn’t really matter.

For your average investor, though, I think he is wrong. The reason is a purely behavioral one. A typical individual investor has a limit with respect to the drawdowns and volatility they can endure before they panic. Investors can only take so much pain before they alter or abandon their investment plan. Since volatility can lead to poor decisions and outcomes, for most investors I think it is a very important component of risk. As is the case with many things in investing, the right answer depends on the specific investor.

The Two Major Sources of Risk

I like to look at risk using a very simple definition. To me, risk is the chance that a specific investor will not achieve their long-term goals.

There are two ways that can happen:

1. Their portfolio can fail to produce the return that they require
2. They can abandon or alter their approach during times of stress, which can lead them to underperform their own investment strategy.

So when I look at risk, I like to look at the things that can produce either of those outcomes.

The first one is the easier one to handle. A portfolio can fail to meet its required return for a variety of reasons, some of which you can control, and some of which are more difficult to. It can do so if the required return is not realistic. For example, if an investor needs a 20% annual return for the next 10 years in order to meet their goals, the stock market is not likely to provide that.

An investment strategy can also fail to meet its required return because the past ends up not being a good predictor of the future and returns are substantially lower than predicted. Or sequence risk could rear its ugly head and a bear market could occur right at the beginning of an investor’s withdrawal phase. There are tools that are available to help manage all of this, but there is always some chance that even a well thought out investment plan will not meet its goals. Responsible planning can reduce that risk substantially, though.

The Role of Behavior in Risk

The second reason an investor can fail to achieve their goals is the more interesting one, and the more important one in my opinion. Measuring behavioral risk is very difficult to do and there is no universally accepted way to do it. When I look at the odds that an investor will abandon their plan, I like to do it in the context of Jim O’Shaughnessy’s two points of failure.

Jim (who I’ve had the privilege to interview for our Five Questions series) often talks about two major ways investors can derail their financial plans. First, they can panic and sell when the market goes down. Second, they can abandon their strategy when it underperforms the market. Passive investors only bear the first of these risks, while active investors bear both.

Although there are a variety of ways to look at these risks, I like to analyze them using base rates. Base rates are just a simple way to look at the past to see what might happen in the future. As an example, if you were to analyze the chances of specific decline in the market in any given calendar year, the simplest method is to just look at the percentage of time that decline has occurred in the past. The table below looks at the odds that the market will lose specific percentages in any full calendar year.

This same table can also be constructed for various combinations of stocks and bonds and other asset classes. We have found that combining this approach with actual dollar amounts based on the money a client is actually investing can be very helpful in looking at the range of possible outcomes and trying to understand how much a client is willing to lose. By focusing on the worst of these outcomes up front, it can help to mitigate the behavioral risk related to abandoning a strategy during a market decline. 

For the second point of failure (abandoning a strategy when it underperforms), a base rate strategy can also be helpful. With factor strategies, looking at the percentage of time each strategy underperforms over various timeframes can be an excellent tool. Using these base rates can help to answer the following three questions, which can be a useful in understanding the risk an investor can endure.

1. How large of a loss can the investor handle before they panic?
2. What is the magnitude of underperformance relative to their benchmark they can endure?
3. What is the duration of underperformance relative to their benchmark they can handle?

Almost everyone has a breaking point. Those breaking points can vary widely, though, with respect to all three of these questions. For example, value investors have been tested on both #2 and #3 over the past decade and many have found that they can’t handle as much risk as they thought. Presenting the historical odds of the range of potential outcomes, with an extra focus on the potential negative outcomes, can help to set expectations in advance and reduce the chance of a bad decision when these outcomes occur.

The Problem with No Answer

There are many ways to measure risk. We all would love to have a simple way to do it, but I am not sure that exists. The way we do it is just one of many options. My point in writing this article was not to suggest that I have risk figured out. I don’t think anyone ever will figure it out completely. My goal was just to outline some simple methods we use to measure risk and an individual’s willingness to tolerate it as it relates to the active strategies we run. If there is any rule to use when measuring risk, I think it probably is that there isn’t one. Risk is ultimately in the eye of the beholder.

Photo: Copyright: 123rf.com / nomadsoul1

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