Managing Risk: Smart Ways to Avoid the Bad and Manage the Good

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Harold Evensky CFP® , AIF® Chairman

Come and join me again in my Wealth Management class.

Good morning, everyone. I hope you all had a great spring break. Anyone do something especially fun?”

“Professor E, I went home to Istanbul to visit family. It was all too short a trip but it was wonderful seeing everyone, as I’d not been home in a long time.” [That was my ace teaching assistant, Cagla.]

“Henry, how about you?”

“Well, I’ve been working on my dissertation, so I hunkered down to move it along. I still have a lot to do but it feels good having such a good start.”

“Excellent. Is everyone ready to get back to the best class in the program? [Needless to say, the class offers a resounding confirmation.]

Okay, this afternoon we’re going to begin with a discussion about two Nobel laureates, Harry Markowitz and William Sharpe. I know you all have thoroughly read the assigned material including some of their seminal works, so my question is this: how would you describe the significance of their work to a client? Katie, why don’t you start with Professor Markowitz?

Katie: Professor Markowitz recognized that in investing we need to consider risk as well as return. That may seem pretty obvious today, but at the time, the sole focus of investors was on which investment would provide the highest return. To the extent risk that was considered at all, investments were simply categorized as conservative or speculative. In fact, for decades, there were lists of legally approved, “safe” investments for fiduciaries such as banks and trusts. For our clients, the significant insight Markowitz introduced was the concept that a well-designed portfolio of individually risky investments could actually result in a safer portfolio. Professor Evensky, may I use the blackboard to demonstrate?

HE: Of course.

Katie: Okay, picture two very volatile investments. Although we expect that over the long-term their returns will be positive, on an annual basis their returns may vary significantly. Basically, this is our expectation of traditional investments such as stocks.

Here’s a simple example:

Managing Risk Chapter Image file - .01.png

Although stocks A and B are both very volatile, they both trend up. As my graph demonstrates, if we were to invest half of our portfolio in A and half in B, we’d end up with an overall portfolio with almost no volatility. Unfortunately, in the real world, we can’t find investments that complement each other so perfectly, but we can find investments that don’t move in exactly the same pattern, or as a mathematician would say, investments that are poorly correlated. That’s the wisdom that Professor Markowitz introduced. So today we don’t think in terms of risky investments but rather in terms of complementary investments; that’s why professional advisors and wise investors are so focused on portfolio diversification.

HE: Well done, Katie. David, how would you explain Professor Sharpe’s contribution to your clients?

David: Well, I’d start with this picture:

Managing Risk Chapter Image file - .02.png

Professor Sharpe demonstrated that there are two fundamental types of risk—unsystematic and systematic. Unsystematic risks are those uniquely associated with individual investments. This kind of risk is considered unrewarded because it’s risk that provides no expectation of extra return.

There are many reasons an individual investment might fail. A company may be badly managed and go belly up, or it might be well managed but fall prey to unfortunate market conditions, such as an energy company facing a collapse in oil prices. From the investor’s standpoint, it doesn’t matter whether the business failure is due to poor management or market forces. If the business fails, the investor is the loser.

At least theoretically, an investor may eliminate this unsystematic risk by diversifying. For example, a real estate investor owning and renting out a single-family home that ends up unoccupied would face a total loss of income, but if he or she owned ten homes, a single vacancy would mean only a 10 percent loss. Here’s what unsystematic risk looks like in the stock market:

April 20, 2010 – BP Deepwater Horizon Oil Spill

Stock Price April 20, 2010 ……..……………….. $50.20

Stock Price Three months later ……………….. $28.74

I can buy a portfolio of five hundred of the bluest blue chips—all the stocks in the S&P 500—but if the market drops 20 percent, that means my diversified blue chip portfolio took a major beating. In my pie graph, that risk is the first wedge of systematic risk—market risk. Many investors say, “I know that and that’s why I buy only high-quality municipal bonds.” Well, as we know, bonds are subject to something called interest rate risk. That means if I buy a bond and a few years later interest rates go up, the value of my bond goes down.

Some astute investors respond by saying, “I know that. That’s why I buy only one-year CDs and roll them over. That way, when rates go up, I get the new, higher return.” That also sounds as if it makes sense, but rates can go down and the investor’s income can drop precipitously. That risk is called reinvestment risk. (See Chapter 18, “Flight to Safety.”) So, although many investors think of bonds as a simple, safe alternative to stocks, the reality is that they come with their own unique kinds of risks.

Finally, there is the last wedge—purchasing power erosion. We all know that throughout time the costs of things we buy and the services we need go up due to inflation. That’s the other real risk of depending on bond income as the sole source of cash flow. Many investors get in trouble by confusing certainty with safety. Bond returns may be certain, but when you factor in inflation as a primary source of income, they’re certainly not safe.

HE: David, well done. I believe your future clients will be well served by your educating them about the wisdom of the laureates.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.