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Risk: What Exactly Is It? by Larry Swedroe
The most commonly used academic definition of risk is standard deviation-a measure of volatility. Unfortunately, two investments with similar standard deviations can experience entirely different distribution of returns. While some investments exhibit normal distribution (i.e., the familiar bell curve), others may exhibit characteristics known as kurtosis and skewness. We will first define these terms and then explain why it is important to understand their implications. Skewness measures asymmetry of a distribution. In other words, the historical pattern of returns does not resemble a normal (i.e., bell-curve) distribution. Negative skewness occurs when the values to the left of (less than) the mean are fewer but farther from the mean than are values to the right of the mean. For example: the return series of -30 percent, 5 percent, 10 percent, and 15 percent has a mean of 0 percent. There is only one return less than zero percent, and three higher; but the one that is negative is much further from zero than the positive ones. (Positive skewness occurs when the values to the right of [more than] the mean are fewer but farther from the mean than are values to the left of the mean.) Behavioral finance studies have found that, in general, people like assets with positive skewness. This is evidenced by their willingness to accept low, or even negative, expected returns when an asset exhibits positive skewness. The classic example is a lottery ticket. On the other hand, in general, they do not like assets with negative skewness. High-risk asset classes (e.g., junk bonds, emerging markets) typically exhibit negative skewness. In addition, some investment vehicles such as hedge funds also exhibit negative skewness. Kurtosis measures the degree to which exceptional values, much larger or smaller than the average, occur more frequently (high kurtosis) or less frequently (low kurtosis) than in a normal (bell shaped) distribution. High kurtosis results in exceptional values that are called "fat tails." Fat tails indicate a higher percentage of very low and very high returns than would be expected with a normal distribution. (Low kurtosis results in "thin tails" and wide middle-more values are close to the average than there would be in a normal distribution, and tails are thinner than there would be in a normal distribution.) It is important for investors/advisors to understand that when skewness and kurtosis are present (the distribution of returns is not normal), investors looking only at the standard deviation of returns may receive a misleading picture as to the riskiness of the asset class-understating the risks. This creates problems for investors/advisors using efficient frontier models to help them determine the "correct," or most efficient, asset allocation. The reason is that efficient frontier models are based on mean variance analysis, which assumes that investors care only about expected returns and standard deviation. In other words, they do not care about the whether an asset exhibits either skewness or kurtosis. If that assumption is correct (investors are not bothered by skewness and fat tails), then indeed, the use of mean variance analysis may be appropriate (though there are other serious problems with the use of efficient frontier models). However, this assumption is too simplistic, as many, if not most, investors do, in fact, care about skewness (especially negative skewness) and kurtosis. If an asset exhibits non-normal distribution (as do many risky assets), mean variance analysis is only a good first approximation of risk, but does not completely reflect investors' true preferences-mean variance analysis will underestimate risk, and the result will be an overallocation to the asset class. Another problem with standard deviation (volatility) as the measure of risk is that investors in the real world generally care much more about downside volatility and far less (if at all) about volatility when returns are above average. Thus investors/advisors may want to consider what is called negative semivariance. Positive and negative semivariance are calculated using positive (and respectively negative) deviations from the mean. Since research into behavioral finance has revealed that most investors are risk averse, negative semivariance should be an important consideration in the asset allocation decision. Another risk measure should be the probability of a negative outcome. This is especially true of risk-averse investors who are more inclined to lose discipline, and stray from a well-thought-out plan, when risk actually shows up. Along the same lines, risk can be defined as the probability of not achieving your financial objective-with the objective generally being not the accumulation of the greatest wealth, but instead having sufficient wealth to allow for the maintenance of an acceptable lifestyle (and not run out of funds while still alive). It is important to note that the expected return of a portfolio should never be considered as a single point, but instead should be considered as a potential distribution of outcomes. The use of a Monte Carlo Simulator can help with estimating the risks (odds) of failure. Another risk, one that is purely psychological, though real nonetheless, is what is known as tracking error risk. For example, U.S. investors that build globally diversified portfolios will experience investment results that are quite different than those experienced by the "market"-with the market defined as a broad major index such as the S&P 500. Some years (i.e., 2000-03) investors will like the divergence, as the tracking error is positive. Other years they may be unhappy with the divergence (1998-99), as the tracking error is negative. Negative tracking error can lead to loss of discipline. Thus investors that are sensitive to the risk of tracking error should consider either minimizing it or avoiding it altogether. While it is true that the asset allocation decision is the most important determinant of returns, it is not the most important determinant of realized investment results. The most important determinant of realized results is instead the ability to adhere to whatever asset allocation is decided upon during the process of designing the investment policy statement. To illustrate this point, consider the following. DALBAR, an independent financial services research firm, found that for the seventeen-year period ending in 2000, the S&P 500 returned 16.3 percent per annum. However, the average individual investor buying and selling individual stocks and no-load mutual funds (average holding period for the funds was less than three years) earned an average return of just 5.3 percent. Asset allocation certainly could not have led to returns 11 percent below those of the S&P 500. Instead it was the persistent shifting of investment strategies that led to such horrendous results. Another risk that should be carefully considered is that of the unexpected negative surprise. Unfortunately, one of the most common and severe mistakes made by investors/advisors is to treat both the highly unlikely as impossible and the highly likely as certain. Prudent investors know that history teaches us that just because something has not yet occurred, does not mean that it cannot, or will not, occur in the future. One has to look no further than to the events of September 11, 2001 for proof of this important point. The potential for negative surprises should be built into any investment plan. Forewarned is forearmed. There is yet another risk investors/advisors must deal with-maverick risk. As Robert Arnott points out, "practitioners 'know' that the greatest peril is the risk of being wrong and alone. As such, we fall prey to the Keynesian dictum that it is more acceptable to fail conventionally than to succeed unconventionally. Decisions that leave an investor alone carry the inherent risk of being both wrong and alone. If an investor is wrong and alone, a strong likelihood is that the assets' owner will not have the patience to see the investment decision through. The decision, even if correct in the long run, will be reversed before it can succeed." We are all familiar with the expression "misery loves company." Experiencing relatively low (but still positive) investment results may create more psychological risks to the investment plan being abandoned than experiencing losses if everyone around is having a similar experience. Another psychological risk is the confusion of strategy and outcome. Investors/advisors often judge the correctness of a strategy by the outcome. This is both a common and huge error. In a world of unclear crystal balls either a strategy is correct before-the-fact or it is not. Consider the case of a family breadwinner with a spouse and children to support. Unless the family is independently wealthy, life insurance is almost always a part of a prudent financial plan. Yet we do not judge the correctness of the decision to buy life insurance by whether or not the beneficiary collected on the policy. Purchasing insurance is either right ex-ante or it is wrong ex-ante. The same must be true of investment strategies. Nicholas Taleb put it this way: "One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision). Like with other risks, confusing strategy and outcome can lead to the abandonment of a well-thought-out plan. Finally, there is one other risk that investment advisors face. That risk is to tell people what they do not want to hear (e.g., we don't know how to beat the market and we don't know anyone that does know either, we cannot design a portfolio that will give you a reasonable chance of achieving your financial goals given your current and desired lifestyle). A good advisor is one that delivers the message regardless of whether or not the client wants to hear it. While it may, in the short run, result in a loss of business, in the long run this is not likely to prove to be the case. And, at any rate, integrity is its own reward. While standard deviation is one important measure of risk, as this paper demonstrates, it is certainly not the only one investors/advisors should consider when developing a financial plan and investment policy statement. The prudent investor considers all of the risks of investing (be they real or psychological) when developing his/her plan Another example of maverick risk is telling people what they do not wish to hear. A contrarian view is often not accepted until it has long been shown to have been correct and has, therefore, lost its relevance. To earn rewards by telling people what they want to hear is far easier, even if the message is wrong, than telling them what they do not want to hear, even if the message is correct. |