How do you define risk? Unfortunately, this rather simple question requires a rather complicated answer. In much of the literature about Investment Management, risk is defined as the standard deviation of returns over some period. Investment Managers use Standard Deviation as a measure of how widely a sample of returns is distributed around its average. In essence, investment risk is measured in terms of volatility – how much it goes up and down.
Findings from cognitive psychology, specifically the growing field of behavioral economics, support a broader conceptualization of risk. Prospect theory (as formulated by 2003 Nobel Prize in economics Daniel Kahneman and the late Amos Tversky) shows how people are much more sensitive to losses than they are to gains. To the point: upside volatility is not experienced as risk; only downside volatility is experienced as risk. Losses cause twice as much pain as gains cause joy. Financial Planners understand this tendency in their clients as they work to keep clients on the wealth management track through periods of market volatility.
Another important finding from the integration of economics and psychology is that our perceptions, thoughts and feelings don’t exist in a free-floating isolation; instead they are generated by the relationship between the current situation and the particular goals we are pursuing. Cognition, as they say, is “situational.” Our perception of risk is the product of this situational cognition. Goals-based investing is the process of matching investments (and their attendant risk) to specifically-defined goals. By helping clients keep their ‘eyes on the prize’, a Financial Planner can help reduce clients’ anxiety about market risk.
Here is an example. Assume you and your spouse have gone to the beach with your three year old child. Your primary goal is to relax and have a good time. The surf that day is heavy and the water is cold. Given your goals and the contextual situation you estimate the risk of swimming to unacceptably high so you avoid it. Now what if, in a moment of inattention, your three year old wanders too close to the shore and is swept out into the surf. Hearing a cry for help, you race towards the water. Clearly, your primary goal has changed: rather than having a good time at the beach, your goal is now saving your child’s life. Under these circumstances, you estimate the risk of going swimming to be much lower, the reward for bearing the risk to be worthwhile, and you charge into the waves.
This example illustrates that the goals you set have a critical impact on your assessment of the risk. Here is a common investment example. Consider someone saving for their anticipated retirement twenty-five years from now. If they consider their primary goal to be avoiding any “loss of principal”, they will invest entirely or primarily in fixed income and cash investments. The goal “avoiding any loss of principal” is nearly certain to make their long-term goal of “retirement” unattainable. A more useful way to frame the question is: To attain the goal of retirement, one must assume a certain degree of risk. In return for accepting a degree of risk, you increase the probability of succeeding in the retirement goal. If you refuse to get into the freezing water, your child is certain to drown. If you get into the freezing water, there is a chance that you will reach your child and save them.
You might have guessed that this means we place little confidence in the usefulness of the “risk tolerance” surveys employed by an unfortunately large number of financial services companies. These surveys fail to include realistic goals in relation to which the willingness to take risk – or the need to take risk – can be assessed. If you want to have $50,000 of income per year in retirement and you have $50 million dollars in the bank, you can afford to invest in CD’s. You also can afford to take more risk. If you have $1 million at retirement and your consumption goal is $50,000 per year, increasing with inflation, you cannot achieve your financial goal by investing only in CD’s.
The retirement plan starts with the establishment of a quantification of the retirement goal. This can be expressed either in a lump sum accumulation at retirement or as a stream of retirement income that the lump sum can be expected to provide (increasing with inflation) over time. Retirement income is more tangible and easier for most people to comprehend than a target account balance. “Where is my spending money going to come from?” is one of the most common questions people ask about retirement. The answer to the question rests, in part, with a realistic rate of return that is required to achieve this objective. An appropriate risk-targeted portfolio is selected based on the least amount of risk necessary to achieve a high probability of achieving that retirement goal.