The Biggest Myths in Investing, Part 9 – Risk Is Something we Can Quantify

This is the ninth instalment of a ten part series similar to what I did with “The Biggest Myths in Economics”. Many of these will be familiar to regular readers, but I hope to consolidate them when I am done to make for easier reading. I hope you enjoy and please don’t forget to use the forum for feedback, questions, angry ranting or adding myths that you think are important. 

The idea of risk is a rather confusing and nebulous concept in modern finance. The traditional textbook definition of “risk” is standard deviation or volatility. This is convenient for academic purposes because it allows us to quantify risk in a portfolio. But this is a flawed concept for several reasons:

1. Volatility isn’t always a bad thing. In fact, volatility with a positive skew is a good thing.  No one complains about a portfolio allocation that rises 20% per year and falls 5% every once in a while, but this is a volatile portfolio relative to many.
2. Portfolio theory does not properly account for the fact that stocks are far riskier than bonds often resulting in portfolios that are not only stock heavy, but even more stock heavy than the nominal allocations imply.¹
3. Negative skew can be a good thing in a portfolio. For instance, many forms of insurance have a natural negative skew and detract from returns, however, it would be bizarre to argue that this is always a bad idea even if you don’t have to use the insurance.
4. Investors don’t live in a textbook world and don’t necessarily judge their portfolios by the academic concepts that drive the way many portfolio managers assess their portfolio performance. This can create a conflict of interest between the investor’s perception of risk management and the asset manager’s perception of risk management.

For most investors the “risk” of owning financial assets is not having enough financial assets when you need them. This arises primarily from two factors:

1. Purchasing power risk.
2. Permanent loss risk.

Permanent loss risk occurs when your savings is declining in value and you’re forced to take a loss for some reason (emergency, behavioral, short-termism, etc). Purchasing power risk is the potential that your savings does not keep pace with the rate of inflation.

In order to visualize how one might protect against these risks in a portfolio it’s helpful to view this concept on a scale showing how our savings can be allocated across different assets:

The investor who wanted to be protected against permanent loss risk would be 100% cash, however, they would risk falling behind in purchasing power by the rate of inflation each year.² Likewise, the investor who wanted to be protected against purchasing power risk would be 100% stocks since corporations earn cash flows by selling goods and services at a mark-up over the cost of production. Bonds, on the other hand, don’t necessarily provide perfect permanent loss protection nor perfect purchasing power protection, but provide an investor with a more blended mix of the two.

A balanced portfolio of stocks, cash and bonds will tend to protect against these risks somewhat evenly. Viewing the world thru the lens of this Savings Portfolio Scale will provide asset allocators with a much more realistic and balanced perspective of how market risk applies to their actual savings. Of course, “risk” has a different meaning for everyone and so we should be careful boiling complex concepts down into single figures that make for neat models of the world. In reality, our financial lives are a lot more complex than that.

¹ – For instance, a 60/40 stock/bond portfolio does not derive 60% of its volatility from the stock piece of the portfolio. Because the stock piece is so much more volatile than the bond component the portfolio will derive more like 80-90% of its downside volatility from the 60% stock piece.  

2 – “Cash” refers to Treasury Bills and other short-term risk-free instruments.