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September 28, 2018

What is Portfolio Risk? How Do I Manage It?

As we mark the 10 year anniversary of the 2008 financial crisis, which shattered the retirement savings of millions and permanently damaged the investor psyche, it is important to revisit the notion of portfolio risk.

There are various definitions of risk. Let’s define some of them:

Volatility, or how much security prices move up and down over a period of time.
Drawdown, or how much an asset can lose of its value.
Shortfall, or probability of not meeting the investor’s objectives.

While volatility is the most common definition of risk, it is not the most important one. Drawdown and shortfall are much more relevant to investors, and can lead to having insufficient funds to buy a house, or not being able to meet retirement goals.

The biggest mistake investors make when it comes to managing portfolio risk is to extrapolate the past and assume that everything will continue based on historical trends. Included in that assumption is the false belief that recent performance trends will continue and things that never occurred in the past will never occur in the future.

The wake-up call from this wishful thinking comes when investors eventually realize that things happen until they don’t. One of the most important failures during the 2008 financial crisis was the strong conviction that home prices will never drop at the national level. We all know now that it is not the case.

Portfolio risk has not been a major factor in investors’ minds over the past few years as stock prices continue to climb up to record levels and equities produced solid results with very little volatility.

As we continue into what may be the late innings of this great bull market, it is important to remind ourselves that low-risk environments do not last forever. Investors need protection from the devastating forces of recessions and bear markets before they arrive, through thoughtful portfolio design and permanent downside protection.

Portfolio construction is a bit like making a good salad. There are abundant options to use. It is rare to have only one (or two) ingredient(s). You can make it in more ways than the number of days in a month. And, it is quite possible that your spouse or co-worker will have a completely different version than you, but will be equally happy with the results. You get the point. Portfolio construction works the same way.

It is important to find the right mix of portfolio ingredients that fit your personal goals with a delicate balance between growth and value styles, domestic and international allocations, financial and hard assets, public and private investments, etc.

It is as important to periodically monitor the portfolio mix in light of changing individual circumstances and financial conditions. If you do nothing, your portfolio will look different tomorrow than it looks today, and it could look a lot different next year than it looks this year. Very few assets have stable values, which means there will be constant distortions.

Taking no risk leads to subpar results, hence avoidance of risky assets is not a good strategy over the long-term.  Currently, consumer price index (CPI), which is a broad measure of inflation, stands at 2.7%, while the average yield of a savings account is 1.2% nationally. It is not hard to see how inflation can eat into your savings and leave you with a negative “real” yield.

Taking excessive risk is no panacea to maximize wealth either. The chances are that once you experience the roller-coaster ride of the global stock markets, you will have an upset stomach and your brain will tell you to get out at the worst time. You will monetize your losses and not be able to recover back to par value since you got out of the market. By leaving the train too early, you will not reach your desired destination.

Humans are known to make judgement errors when it comes to allocating their assets across various investment categories, since every human is full of emotions and biases that get in the way of making intelligent investment decisions.

No single asset class, country, investment sector, or individual stock outperforms consistently; none! So, why bother trying to predict the home run investment for the next year when the odds are great that what did best in the past will likely disappoint in the future.

Assessing your individual risk tolerance through both economic and emotional factors is the best way to start the portfolio construction process, rather than blending a haphazard mix of products based on past results. Wall Street is famous for manufacturing innovative products to lure you, but it is also known for bringing them to the market at an inopportune time.

Risk assessment process should not only consider your age, wealth, and time horizon, but also qualitative aspects, such as your willingness to trade off risk versus return, the anxiety created by portfolio losses, and your concerns about meeting your financial goals.

The by-product of the risk assessment is a carefully designed portfolio with a diversified mix of ingredients that collectively should let you sleep well at night, not thinking about how it will behave under different market conditions.

The level of risk embedded in your portfolio should be commensurate with the amount you are able and willing to tolerate, therefore there should not be any surprises when markets go through their usual (and sometimes unusual) up and down gyrations.

The most important factor for long-term success is to maintain a long-term investment horizon and exercise patience when something does not seem to work out as you expected it. Staying on course is as important as setting the right portfolio mix.

We are here to help you with all your investment decisions and guide you to your desired destination.

Erman Civelek, CFA, CAIA, CFP
Investment Strategist

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