Opinions Investor's Corner Investor's Corner: Focusing on the important meanings of risk
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Investor’s Corner
By John Gudritz CFA
Principal
Front Street Investment Management LLC
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Risk is a word that is used a lot in the investment management business and it has many different meanings. Most people associate the word with the possibility of losing money in an investment. However, within “the business” it is used and misused in many different ways.
If you ask investment professionals what they think of when they hear the word “risk,” they might talk about volatility or the degree to which an investment moves up and down in price. The more volatile the price movement, the more risky the investment is considered to be. This definition of risk of the investment can actually be measured by statistical concepts called the “variance” or “standard deviation.”
Briefly, these concepts measure the variability of data points around the average (or mean) of the data. For example, a stock might have an average price of $25.50 over the past month. The variance or standard deviation would measure the difference between the stock price at the end of each trading day of the month and the average price for the month. The further away each day’s price is from the month’s average, the higher the variance and standard deviation.
I have always questioned the logic of labeling an investment as risky just because its market price tends to be volatile. First of all, most people don’t associate risk with rising prices, or what we professionals call upside volatility. A stock could be considered risky by those who only look at statistical measurements, even if the price climbed upward day after day for years. I don’t know about you, but I will take that risk all day long.
To me, risk should be associated more with valuation or price levels in relation to economic fundamentals than to just the daily price act ion of the investment. With this way of thinking, it is possible for an investment to become less risky as the price goes up or goes down. It all depends on what is happening to underlying economic fundamentals of the investment in question.
For example, a company could announce that their prior quarter was disappointing because one of their large customers delayed an order and did not buy as much as expected. The management might say that they are confident that they will get that order at some future time, but the stock price might fall anyway.
If my research convinced me that the company’s long-term fundamentals had not significantly deteriorated in any way, I would look at the price decline as an opportunity to invest in an asset that had just become less risky. The stock price is lower on an absolute basis but, more importantly, also in relation to the company’s fundamentals.
The statistical measurement of risk would not agree with my assessment. In fact, it would probably show that the stock just became more risky because of the large decline in the price. To say this asset is now more risky is not logical to me.
Investment professionals also tend to measure risk on a relative basis rather than on an absolute basis. That is, risk is earning a return that is worse than an index.
In 2008 most managers were able to show their clients that they earned their fee by losing less than the stock market despite the fact that their clients’ equity portfolios were still down over 30 percent. They did not understand why their clients were not grateful for that “accomplishment.”
The fact is defining risk on a relative basis is a concept only an investment professional could love. The clients think on an absolute basis because that is money that they will need now or in the future. The concept of “losing less than the market” has no concrete value that can be spent. It’s an attempt at emotional relief by suggesting that it could have been worse.
Investment professionals also give too much weight in designing an investment strategy to the tolerance of the client to take risk, in my opinion. While we want our clients to be comfortable with the possible volatility that the investment program could experience, it is much more important to be looking at their capacity to take on risk.
We learned in 2008 that people must have the financial ability to take on risk even if they have the inner ability to tolerate it. Their financial resources must be able to provide a margin of safety that will allow risky assets to fail without totally altering their long-term financial future. Fortunately I think that concept has been learned to some degree as we have seen retirement assets becoming more conservatively invested over the past year.
John W. Gudritz CFA is a principal at Front Street Investment Management LLC, a fee-only investment management firm in Traverse City.