On Risk and Return:
Adapted
from "Weighing Risk against Return Can be a Risky Business" by Karen
Slater, The Wall Street Journal, August 1989
Most
investors know they are supposed to be weighing risk against return in making
investment decisions. But how does one put a number on the riskiness of a
particular investment or portfolio?
Financial
professionals use several measures that can be valuable for individuals in
planning their portfolios. In particular, quantifying risk is a big part of
"asset allocation," a service whose popularity has grown since the
1987 stock market crash.
Unfortunately,
like many aspects of managing one's money, gauging investment risk is both more
complex and less certain than most people would like.
"Some
people think that when you have a model, because it's scientific, you get the
exact right answer. But this is still a judgment game, " says IT1
Consider,
for instance, the varied portfolios recommended by a sampling of financial
advisors and asset allocation specialists, including IT. They were asked to
design a portfolio that would take the least risk while having an expected
return of 10% a year.
All four
specialists put a minority of the funds in common stocks - traditionally seen
as one of the riskier investments - and emphasized a mix of cash equivalents
and bonds. But the variations were considerable: The recommended commitments to
bonds, for example, ranged from 2% to 50% of the portfolios; the range for
stocks was zero to 36%.
So what is
this thing called risk that financial professionals can gauge so differently?
Risk has
traditionally been equated with the volatility of investment returns. Small
company stocks are deemed riskier than large company stocks, for instance,
because the best years for small stocks have been more stupendous and the worst
years more sickening.
Along
those lines, financial advisors often measure the "standard
deviation," or variance, of an investment's short-term returns from its
own average return over a longer period. Standard deviations are calculated for
entire portfolios to size up the best and worst performances they are likely to
turn in.
Similarly,
investors may see references to "beta," a calculation of the
volatility of a particular stock or mutual fund relative to a broad market
indicator such as the Standard & Poor's 500 stock index.
The lower
the beta or standard deviation, the lower the risk.
Many
financial advisers aim to construct portfolios that are unlikely to do worse in
any single year than individual investors determine they can stomach
financially and emotionally.
"It
comes down in many cases to a gut level decision," says SBE2 .
"Ninety-five percent of the clients want no more than a 10%
loss."
Calculation
of future risk, however, is the subject of much debate. For instance, is it
appropriate to use the high volatility of bond returns over the past several
decades, or someone's best guess?
A minority
of advisers declares that the whole approach is flawed. Their alternative is to
draw up various economic scenarios for the coming year and to estimate the how
different investments would fare in each case.
"We
want to understand how much risk we are taking now, not how much risk one would
be asking on average over along period of time," explains HRL3.
But some
see peril in the scenario approach. "That is just fine in principle,"
says WFS4. "But there is a tendency for people, when they write
down a limited number of scenarios, to not put down really extreme scenarios or
attach a high enough probability to the extremes."
Practitioners
may also disagree about how a particular type of investment will perform in a
particular environment over the coming year. M.D.Sass5 currently
estimates that stocks would post a one-year loss of 18% in a recession. Bailard
Biehl6 puts the investment loss at only 5%.
Advisers
say some risks aren't adequately addressed by the standard mathematical
measures. Where real estate investments are concerned, for example, there is
the risk of having to wait months to find a buyer.
And
analyses based on the expected returns and price fluctuations for different
investment categories, such as stocks or corporate bonds, don't fully address
the risks associated with individual issues within those groups. For example,
it may make perfectly good sense for an investor to be in the bond market, but
being in certain issues may be very risky because of the chance of default.
But
investors really need to evaluate risk with two time frames in mind, says HRL:
"There's the return they need over the long-term and how much pain they
can tolerate between now and then."
JM7
says: "Some people, in trying to avoid risk, put all their money in
Treasury bills. But the likelihood of their achieving their wealth goals may be
virtually zero."
Advisers
can address that longer-term risk by estimating the portfolio return an
investor needs to build enough cash to meet long term goals. Then, usually
using standard deviations, they can also calculate probabilities that a
particular portfolio will deliver that target return or, say, beat inflation
over an extended period.
Indeed,
that focus on long term goals should be the starting point for evaluating risk,
says RG8. Starting from short-term volatility, he says, "is a
'trees' kind of answer rather than a 'forest' kind of answer. I think you want
to look at the forest first."
1. Irwin
Tepper, president of asset-allocation firm in Newton MA
2. Steven B. Enright, financial planner, Seidman Financial Services, NY
3. Hugh R. Lamle, Exec VP of M.D. Sass Investors Services, NY
4. William F. Sharpe, Nobel Laureate at Stamford University
5. See Note 3 above
6. Bailard, Biehl & Kaiser, investment advisers, San Mateo, CA
7. John Markese, director of research for American Association of Individual
Investors in Chicago
8. Richard Grinold, director of research at BARRA, a Berkeley, CA