What’s The Real Risk In Your Portfolio?

What’s The Real Risk In Your Portfolio?

Risk is a commonly used term when it comes to investing, and its importance cannot be overstated. While we cannot control the returns that we get from our investments, we can and should manage the risk very carefully.  As I have written before (Don’t Overlook the Risk of your Investments), there are many different types of risks that apply to different types of investments.  But when advisors talk to their clients about overall investment portfolio risk, they typically use mathematical data to explain it.  I offer a different interpretation that I believe has more utility.

Let’s start with the mathematical definitions first.  They are useful in that they are objective and quantifiable, and can help with comparisons between investment choices.  The most common definition of risk is the volatility of returns, as measured by standard deviation (SD) or its cousin, variance.  These are simply measures of how widely the returns vary over some period of time.  Using this measure, a riskier investment is one with a higher SD or variance.

But what if two investments have very different expected returns? Is SD sufficient to describe and compare them?  Well, there is a measure that integrates both risk and return.  It’s called the Sharpe Ratio, after Bill Sharpe, one of the originators of the Capital Asset Pricing Model for which he and others received the Nobel Prize in Economics. The Sharpe ratio divides an investment’s historical return (actually its excess return above what’s called the risk free rate) by its SD to measure its risk-adjusted return. The number will tell you two things. In absolute terms, if an investment has a Sharpe ratio greater than 1, it means that the investor is being adequately compensated for the risk he/she is taking. If less than 1, you might conclude that the investment is too risky to be worth the return it has generated. When comparing different investments, the higher the number, the better the fund has performed relative to its volatility or risk.

The problem with the Sharpe Ratio is that it does not differentiate between downside volatility (which all investors fear) and upside volatility (which investors love).  A variant of the Sharpe ratio is the Sortino ratio, named for Frank Sortino but actually created by Brian Rom. It takes into account only the downside volatility (as measured by semi-deviation). When there is skewness in the performance of an investment over time, the Sortino ratio can give you more insight into the true downside risk of lower returns which is what investors really care about.

While these kinds of risk measures can help you choose from among different investment choices, they don’t provide much actionable insight about the risk of an overall diversified portfolio consisting of many different holdings. If you knew that the Sortino ratio of your portfolio is 1.5, for example, would you change anything? Some advisors estimate “sound bites” such as the number of years the portfolio would have lost money or the most it would have lost in 2008 for their clients in an effort to make the embedded risk more comprehensible.  But while such information may be useful in calming (or stoking) fears, it may not encourage the right behavior because it focuses on emotion rather than on rational-based action.

I suggest that the better definition of risk ought to be based on the reason we invest in the first place, namely to fund all the things we want to do for the rest of our lives.  In this context risk would be defined as the likelihood that we don’t get to achieve all our future goals.  This is not calculable using the kinds of measures above but rather through goal-based financial plan outcomes or Monte Carlo analyses that estimate to what extent our money may not outlast our lifespans.  Although imperfect, this approach to identifying portfolio risk is much more aligned to what we are trying to accomplish than any of the risk measures above.  Best of all, if understanding this risk stimulates change, it will be in a direction that improves one’s lifestyle. That’s what the concept of risk really should be all about.

 

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