Perceptions On Investing – Risk, 3rd in the Series

In the first two articles of this series we focused on attitude and behavior. Investor behavior has far-reaching influence and maybe no where is it more clear than in dealing with your own chosen asset allocation.

How do we define risk in terms of retirement?

There are many definitions of risk depending on what particular aspect of investing is being discussed. In this article we will focus on the main subject area, risk associated with retirement funding. Note that the number and length of discussions on risk on the Boglehead forum are legion. In other words, investors have strong beliefs in what they view as risk, and views vary according to personal feelings, personal circumstances, and even genetics.

There are two basic risks associated with retirement funding:

  1. The risk of not having enough to reach your needed retirement goal, and
  2. Risk of not having enough for retirement due to taking too much risk at the wrong time.

There are some investors who are risk averse from the start and hesitate to use any equity, and there are investors who become risk averse after encountering their first market crash. On the other hand, there are investors who have no fear of substantial losses at all. These investors believe that any and all market crashes will recover in a reasonable time period. Sitting at either end of the range is probably not prudent, but you can review the following and decide for yourself.

Anatomy of a market crash
stock_market_crash_1987

1987 stock market crash

This is simplistic, but it provides a different framework for viewing risk.

What triggers a full-blown market crash? Some dire event? Some negative fundamentals? Actually no, it’s really investors selling as a reaction to something. Daily market volatility is the result of the normal daily hum of news and events as investors try to profit or to keep from losing money.

Big news and events–and the biggest reactions to them–are always caused by bad news because investors don’t want to lose money. Primal instincts take over in a panic and investors sell first and ask questions later. You’ll never see such reaction to very good news.

Actually, the lowly individual investor may not even know or understand the bad news, he or she is reacting on the market drop. Crashes may start with instantaneous and automatic selling on the first whisper of bad news and this small snowball creates the avalanche. You, lowly investor, are going to be last out, and by the time that happens, the fast money may be the ones buying your shares. The take away here is other investors emotions are your biggest enemy, but you also need to realize other investors will be buying again at some point. Your smartest move is to not get caught up in this roller coaster ride.

The nature of risk

William Bernstein defines two types of risk — shallow risk and deep risk. Shallow risk is defined as a temporary drop in the market. Shallow risk is what we encounter in our daily investing lives. Shallow risk includes bear markets, flash crashes, and even black swans. Black Swans are surprise, out-of-the-blue, events that can’t be anticipated. Investors cannot invest and avoid these risks.

Shallow risk can cause serious damage and last for several years, but it isn’t permanent. Shallow risk is strongly linked to market volatility, and Benjamin Graham, decades earlier, called it “quotational risk” in an attempt to frame it in a way that investors would not fear it, just as Bernstein has done with the term “shallow”.

In contrast to shallow risk, Bernstein defines deep risk as substantial losses that never recover, at least not in a time frame that the investor can tolerate. Deep risk is associated with inflation, deflation, confiscation, and devastation. One common behavioral problem investors have is converting shallow risk to deep and permanent risk by selling in a market crash.

More information on shallow risk and deep risk comes courtesy  of Jason Zweig.

Risk considerations and emotions

In assessing risk, we need to think about our need to take risk, our financial ability to take risk, our willingness to take risk, and the uncertainties of accurately analyzing risk. Risk tolerance can be divided into two major categories; external factors and the psychological make up of the investor. Need and ability may be distorted by emotions, but willingness is where emotions and behavior really cause problems, and it’s much harder to analyze than external factors. When investors think of risk, they think very analytically, but they don’t think that way under severe stress.

ktchartAccording to Kahneman and Tversky, the pleasure of gaining $20,000 is only about half of the pain experienced in losing $20,000. Because investors are risk averse, they engage in some very harmful behavior when they feel the stress of losing money, even if it’s a temporary loss. Investors are probably better off if they consider that they are very likely to get asset allocation wrong if they haven’t been truly tested in a panic crash.

Risk is real
Japanesestockmarket

Japanese stocks (price index)

Can we be completely assured that volatility (shallow risk) is always going to remain shallow risk? The performance of the Japanese stock market is an example of what seemed to be shallow risk that turned out to be deep risk. The Japanese stock market hit an all time high 25 years ago and it now sits at about 1/3 that level. It only takes one such event to prove that stock investing is indeed risky. So, can we be assured that shallow risk will always recover? The answer is no, which is precisely why the market is risky in any time frame.

Black swans
220px-Black_swan_jan09

Cygnus atratus

Taleb

Nassim Nicholas Taleb

Up until 1697 the western world believed that all swans were white. When a black swan was first discovered in Australia by Dutch explorer Willem de Vlamingh, it was a shock.

 

Nassim Nicholas Taleb famously used the black swan analogy to describe a market event that is a stunning surprise. Such an event is rare and it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme ‘impact’. Needless to say, investors will not be prepared emotionally for an event they could not imagine. You might consider these facts when developing your asset allocation. It is far better to not put everything at risk than to sell out because something happened you could not even imagine.

The Long Run

Many investors believe that stocks are safe in the long run, but how long is the long run? In the accumulation phase it may be somewhere in the range of 20-25 years. If you are in your 20s or 30s, then you have the opportunity of the long run, but when you get less than 20 years away from retirement you may begin to feel the effects of shorter term market and economic volatility.

Rolling 5, 10, and 20 year annualized returns from 1950 to 2010.

time high average low
5 years 26.2% 7.5% -8.5%
10 years 16.8% 7.3% -5.1%
20 years 14.4% 7.2% 2.4%

First thing to note is you can have a 10 year stretch that seriously underperforms the long-term average.

Then there are some implications in this data that are not readily apparent . One problem with shorter term volatility and returns is the sequence in which they occur. If you hit a bad sequence within 10 years of retirement or just after retiring it could have a lasting impact on your lifestyle.

retirementriskzoneThe long-term will not save you if you encounter a bad short-term period at the wrong time. As the volatility of returns decreases over time, the dispersion of possible final portfolio value increases.

Of course the impact of sequence and the magnitude of possible outcomes is directly related to the amount of stock in the portfolio .You cannot make a decision without it having an adverse impact somewhere else. No equity eliminates stock risk, but greatly increases shortfall risk. Having all equity decreases the possibility of shortfall risk, but it increases the possibility of the damaging effects from sequence risk and a poor outcome due to the bad luck of ending up with a low total portfolio value.

So, as with almost all investing decisions, awareness helps, but in the end the best approach is usually a blend of balance and compromise.

The risk-taking gene

Yes, there really is a risk-taking gene and it plays a significant role in how an investor fundamentally views risk. Exploring genetics and risk-taking is beyond the scope of this article, but you can find more information here:

The study, for the first time, links specific variants of two genes that regulate dopamine and serotonin neurotransmission to risk-taking in financial investment decisions.

A slightly different view point
JohnHohn

John Hohn

Financial advisor John Hohn, now retired, wrote a very informative series of articles on risk in 2011. Hohn provides some perspective from someone who has dealt with many different types of investors and he provides a little broader look at investor behavior. In the link above you will find four articles on his observations. In one article you will find a link to a Flexible Retirement Planner (FPR). Note, though, the uncertainty of the various input requirements can greatly affect the results.Here are a few quotes from Hohn’s articles that reflect his experience and his viewpoint.

  • The losses that have the longest lasting impact on your portfolio are those that you allow to influence your better judgment, lead you to admit too much emotion into your decisions and prompt you to abandon a disciplined and structured plan approach to managing your money.

We know that defining risk as a percentage loss does not give a vivid picture of potential loss for most investors, and we have substituted a dollar amount instead. Hohn believes that translating the dollar amount into other values is even more effective. He provides these examples:

  • Putting market losses and gains in perspective is always important. Emotional turmoil inevitably increases when the absolute dollar amount of the loss is translated into other values.
  1. “There goes our plans for a new car down the drain.”
  2. Or, “No vacation for the next three years.”
  3. Or, “We are going to need to keep your mother with us, now. We’ll never come up with the money for the retirement home.”
  • Time is money. When you are retired, money is time. The retiree must keep investing decisions as free of emotion as possible. One of the better ways to do that is to look at money as time. Another blog, The Finance Buff, made this point very clearly back in December 2008.
  • Rather than recognize that they were now doing well…they enshrined their losses. They could not think about their portfolio without thinking about their losses.
  • Never adopt a riskier asset allocation in the hope of satisfying a psychological goal.
  • Every day is a new day. Every year is a new year. Wipe the slate clean and do as well as you can.

In summary, there are many factors that influence how much risk an investor should take. The acceptable range is wide, and the better understanding an investor has, the more able he or she will be in managing risk and staying the course. It would appear that opting for no equity or 100% equity is not a prudent choice. And if a new investor has not experienced the emotions associated with a market crash, he/she would be wise to limit allocations to 70-75% equity. The way to get your fair share is not to shoot for highest returns, it is to minimize behavioral mistakes.

 

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September 2014
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