While often debated, under Modern Portfolio Theory’s (MPT) purely statistical approach to passive portfolio construction, risk may be defined as “the unexpected variability of returns measured as the coefficient of variation, which is calculated as the standard deviation divided by its mean return.” Simply put, they typically define risk as the deviation from average performance.
This definition is particularly troubling. While we have seen the stock market dip to deep lows, we have also seen it swing rapidly to greats highs, as in 2013. So history begs the question, “Aren’t higher than average returns a good thing?” Why does MPT choose to regard higher than average returns as ‘risky’? This is a problematic consequence of choosing the standard deviation as a measure of risk. Punishing all deviation from average, including positive deviation, inherently drives investment results to achieve exactly, precisely, and only average performance. Average may feel great if you are otherwise hopelessly floundering, but it’s not what’s expected from a proficient practitioner.
A dictionary definition, on the other hand, says: “Risk is the probability of portfolio value loss due to market factors.” That’s pretty simple. Risk is the probability of losing money.
We Believe There are Three Broad Categories of Investment Risk
is the probability of losing money along your way to your goal. Basically, it’s the same as the dictionary definition. Hilbert Financial Group measures risk as the probability of loss of real money over a one year period. This approach to risk is often linked to one’s experiences and emotions and can play directly into your overall risk tolerance as an investor. This is a measure that matters to most real people (as opposed to academics), and thus is a useful measure that correctly drives investment decisions to reduce risk without punishing returns.
is also emotionally linked, like Journey Risk, but is a comparison of what may approach the ideal set of investments decisions for a particular goal as opposed to the results of the actual decisions that are made. This is the risk of regret and can measure what could have been achieved. This type of risk is most often seen when investors become too cautious and conservative or take on unnecessary risks by making emotional investment decisions rather than following an objective unemotional path.
In the words of Robert Arnott, “In investing, what is comfortable is rarely profitable.”
is likely to be the greatest risk you will face. Destination Risk is the probability that at retirement or the arrival of a major life event, savings prove to be insufficient to meet your needs and goals. This risk is about the really big picture of your life, not what happened last month or last year. While we all like to imagine a comfortable retirement with plenty of cash available, failing to achieve sufficient long-term returns creates big risk for long term goals. Those plans might be CANCELED and replaced with a new reality leaving you with two choices: you could either live in a small shack with only beans to eat, or may have to skip retirement altogether and work until you drop. While hopefully an exaggeration, the point is that good returns are required to reduce Destination Risk.
Modern Portfolio Theory focuses only on relatively shorter-term investment risk and does not address the longer term destination risk problem at all — which may result in winning the battle but losing the war.