WHEN IT COMES TO INVESTING - WHAT IS RISK, REALLY?
Cam Watson, 30 July 2018
In the finance world, risk is traditionally defined as volatility of returns or the risk of losing money. Sometimes it is expressed as the chance that an investment will not do as well as expected.
All of these definitions and concepts remain valid and important, but don’t quite go far enough.
Any attempt to define risk should start by asking why people invest. In the real world, outside the textbooks, people save and invest for all sorts of reasons. Investing is not an end in itself. Most of us invest, not for the fun of it, but so we can do things; like retire, take a trip, provide a legacy, establish a charity or buy a house.
In other words, people invest to achieve their goals. This being the case, some academics and advisers* believe wealth managers should change their definition of risk from volatility of returns to the probability of not achieving goals.
Linking risk to goals provides a framework in which all the other types of risk can be considered. For instance, consider someone who is investing for 30 years and needs their portfolio to provide retirement income over this time, but who refuses to own any growth assets like shares because they are too risky, and only wants to invest in term deposits.
While this person will avoid the volatility of returns that come with investing in shares, depending on how big their nest-egg is, they run the real risk of outliving their money.
Shunning growth assets may leave them exposed to inflation. The probability of achieving their goal of having a retirement income for 30 years may be lower than if they opted for a more diversified portfolio.
Instead of ‘risk and return’, think ‘dreams and nightmares’.
At the other end of the spectrum, a person in the same situation but who wants to invest only in shares has the potential to earn higher returns.
However, they will also face more volatile returns. They will need to have the fortitude, and financial capacity, to sit through some perhaps nasty market declines. Selling at the wrong time can undermine long term goals.
Again, taking a more diversified approach can mitigate market falls, and may improve their chances of hitting their long-term goal.
An adviser’s key role is to talk to clients about their goals, help them refine these goals, and then to consider a plan and investment strategy to meet those goals.
When talking to clients about goals, Florida-based wealth manager Jean L.P. Brunel CFA, likes to ask them about their “dreams and nightmares” rather than talk about “risk and return”. In his view, this helps move the discussion beyond dollars and cents.
Asking “what are your dreams?” can help you prioritise your financial goals while asking “what are your nightmares?” can help define what risk really looks like to you.
A goals-based approach to financial advice ensures the focus in on the long-term. It also provides a more meaningful definition of risk - the chance of not meeting those goals.
* Such as wealth adviser Jean L.P Brunel, CFA, as outlined in his paper Goals-Based Wealth Management in Practice, CFA Institute, March 2012 and academics Sanjiv Das, Harry Markowitz, Jonathan Scheid, and Meir Statman in their paper, quoted by Brunel, Portfolio Optimization with Mental Accounts, Journal of Financial and Quantitative Analysis, vol. 45, no. 2 (April 2010):311–334.