CHAPTER SIX
REDEFINING RISK MANAGEMENT

CONVENTIONALLY DEFINING RISK

ONE OF THE first steps to developing a financial plan involves taking an accurate assessment of what you own and owe, along with your sources of income. The next step is to get a handle on your attitudes toward risk and a clear understanding of your goals and objectives. This might be determined from a series of questions that you ask yourself or from an interview with a financial planner. The answers to these questions are important components in determining an appropriate investment plan because your risk tolerance level determines your overall approach to investing.

Investors define risk as the probability or likelihood of losing money. Here is a listing of risks that are traditionally of concern to investors:

Market risk—the probability of losing money in the securities markets

Interest-rate risk—the chance of being tied to a low rate for a long period of time when interest rates go up

Reinvestment risk—the investment of future cash flows at a reasonable rate of return

Credit risk—the chance of a company failing to meet its obligations

Common factor risk—nondiversification

Inflation risk—changes in the real value of money and investments Holding period risk—the chance you have to sell too soon (or hold too long)

All of these risks are legitimate and should be considered when constructing an investment plan. Once it is determined whether you are a risk taker, a risk avoider, or somewhere in between, a specific plan can be constructed.

If you are working with a financial planner, a plan is eventually agreed upon, implemented, and on a periodic basis the portfolio’s performance is reviewed and the investments rebalanced. Many financial advisers develop what is called an Investment Policy Statement (IPS), which summarizes the fundamental investment goals and objectives and how these goals will be achieved. The IPS states the asset allocation targets, boundaries, and diversification parameters in an attempt to match the limits of risk that the investor is willing to assume. It includes guidelines for determining specific asset classes and allows for excluding certain types of companies from the portfolio.

Diversification Reduces Risk, but Does Not Eliminate It

One of the most important parts of the plan will include some sort of “asset allocation,” which is the process of identifying and selecting asset classes and determining the appropriate percentages for the portfolio (in other words, figuring out how the money is to be divided). By examining historical data, the planner (and trusty computer) can determine an optimal mix of asset classes, subclasses, and so on, that increase the probability of an investor achieving the agreed-upon goal at a certain risk tolerance.

The decision of how much goes into each category (stocks, bonds, or cash, for example) has proven to be even more significant than the selection of the specific stock, fund, real 107estate, or other investment and may account for as much as 80 percent of the overall return on the portfolio.

A study conducted by Brinson, Hood and Beebower in 1986 concluded that 93.6 percent of a portfolio’s performance depends on asset allocation. The study concluded that the asset allocation decisions made by investors are by far the single greatest determinant for future investment success.¹ The money management industry has been preoccupied with the role played by asset allocation ever since this proposition. Brokerage firms continually update and publicize their calculation of the ideal asset allocation mix.

Historical data indicates that when one class is doing well, another may be decreasing or not increasing as much. The measure for this difference is called the correlation coefficient. If your portfolio consists of investments that are negatively cor-related—meaning that if one is going down the other is going up—it gives you more diversification and consequently less risk. This is a great idea in theory, but history doesn’t always repeat itself. For example, the stock market doesn’t always go up when interest rates go down. International markets don’t always go in the opposite direction of U.S. markets.

By using diversification to smooth out the ups and downs that occur in each asset class, risk is reduced. This process was invented in the early 1950s and was described in the book Portfolio Selection by Harry Markowitz.² University professors with scholarly statistical backgrounds expanded on the work done by Markowitz. Wall Street and investment professionals picked up these academic theories in the 1980s. Computers cranked out statistics, and trendy risk measurement jargon such as alpha, beta, and R Square were bantered about and began showing up in client reports.

The basic principle behind all the statistics remains the same—diversification reduces risk. The problem is that diversification does not eliminate risk. Diversification can reduce the risk of owning stock, but it can’t reduce the risk associated with 108macroeconomic events that can threaten all businesses. This risk, referred to as systematic or market risk by the number crunchers on Wall Street, is essentially the risk associated with the overall market decreasing.

To summarize, traditional investment risk management is a simple process. First a long-term investment plan is created with asset allocation percentages that match your goals. Then the portfolio of investments is selected and is properly diversified to guard against the risk associated with having too much in any security. The focus is maintained on long-term goals. The basic assumption is that the markets have a history of short-term ups and downs but always go up over time.³

Market Timing or Random Luck?

Wall Street has always had a problem dealing with systematic risk. Hypothetically, investors could attempt to reduce this risk through market timing, which involves strategically determining when to buy and when to sell. As we know, timing is everything; hence the old adage “buy low, sell high.” But how do we know when we have reached the lows and the highs? The answer is simple: we don’t, and neither does anyone else. Timing the market, like beating the market over the long run, is the stuff of dreams. The overwhelming conclusion of research on this topic is that any success in market timing is based purely on random luck.

Since market timing doesn’t work, advisers recommend a benchmark strategy of buying and holding. This passive strategy calls for purchasing an investment and leaving it alone for a long time. Periodically, you would “rebalance” your investments so that your asset allocation percentages remain in line with your investment plan.

Market risk is supposedly mitigated by our unfailing faith that stocks will do well over the long run. As a result, professionals expend a lot of brain cells on calculating beta—a portfolio’s sensitivity to market risk. Beta is simply a measure of 109volatility. A portfolio with a relatively low beta means that if the overall market goes down, the portfolio will also go down in value but not as much as the market. So if the market is down 10 percent, a low beta portfolio may only be down 5 percent. This applies to rising markets as well. If the market is up 10 percent, the low beta portfolio may be up only 5 percent. A low beta portfolio may be termed conservative but could still go down in value if the market goes down.

Many investors (as well as advisers) focus on the beta. If you buy into the theory that the market always goes up, you’ll focus on the risk of not doing as well as the market does, or missing out on upside gains. This is why many have opted to purchase index funds that go up and down in tandem with a particular market index. The risk of deviating from the market averages is virtually eliminated with an index fund. Indexing will be discussed in Chapter 8.

Computer Modeling

I agree that employing historical data to come up with an investment plan is useful, but it is overplayed by the investment community. The average person can be taken in by the impressive computer modeling accompanied by the array of graphs, pie charts, and statistical references supplied by investment advisers. I’ve concluded that most of this information isn’t useful and is basically fluff to give clients the impression that they are dealing with a firm and/or person with superior intelligence. The complexity actually seems to increase investors’ comfort level. But the projections do nothing to reduce market risk and are correct only insofar as the assumptions are accurate.

In the late 1940s, scientists at Los Alamos National Laboratory programmed their computers to create random combinations of known variables to simulate the range of possible nuclear-explosion results. They nicknamed the program Monte Carlo, after that city’s famous roulette wheels, and used it to 110find patterns that would let them plot the probability of different outcomes.

Today, many financial planners use Monte Carlo–style simulation calculations to determine how long a certain amount of money invested in a certain way will last if drawn upon for retirement. Baseline information, such as age, current value, and composition of investments, is plugged into the program along with assumptions such as life expectancy, future inflation, and investment returns. The program spits out the amount of money you can comfortably withdraw each month with a certain level of probability.

This is a nice retirement planning curiosity, but that’s about it. Investment return assumptions are usually based upon past history, which isn’t necessarily going to repeat itself. The simulations can’t accurately project how markets will behave in the future, and as a result the computer projections may give the retiree a false sense of security.

Inflation Risk

The possibility of losing the purchasing power of your capital is inflation risk. This is usually the primary justification for investing in the stock market. If the purchasing power of the dollar becomes less and less over time, we need to have some mechanism for staying ahead of the erosion. Real estate and other tangibles have proven to be good inflation hedges while having their own unique risks. Low-interest accounts, such as checking and interest bearing CDs, are usually a poor inflation hedge. A long-term commitment to the stock market has traditionally been considered a good inflation hedge. However, as stated earlier, an investment in the market subjects us to the most challenging puzzle of risk management—market risk.

It is forever essential to have a healthy respect for risk and its potential to destroy wealth. Uncertainty of the future is a constant issue. A man-made or natural disaster such as terrorist 111hostilities or a massive earthquake could occur without warning at any time. These types of events can have far-reaching economic consequences. Most people ignore these risks, taking comfort in the certain data of the past and believing that it is a reasonable forecast of the future. We have the unique ability to rationalize away the lessons of our past. This excerpt from an article published in the late 1920s could easily be compared to the overheated market of the late 1990s:

As long as human emotions are a factor in financial decision making, we are likely to repeat the lessons of the past and experience periods of frenzied euphoria followed by times of despair and depression.

Acceptable Risk

I consider myself a conservative investor. I don’t mind not making as much as the market when it’s going up, but I definitely don’t want to lose money. I would like to see my overall investment portfolio increase in value each year regardless of how the market performs. A 10 percent drop in value is unacceptable to me. It’s irrelevant whether I lose less than the overall market. What if the market is down 40 percent? Is it supposed to make me feel good if I’m only down 20 percent? That doesn’t make sense. I want protection against loss!

Even though the market may have been one of the best places to put money over the last sixty years, I am not going to put my blind faith in the consensus that it will be so in the future. Trust just doesn’t cut it anymore. The betrayal of trust by corporations, brokerage firms, accountants, and regulators has taught me that much. I look at the future of market returns simply as a string of random numbers. Some years the numbers are positive. Some years the numbers are negative. And in some years they are basically unchanged. Of this I am certain.

Given what I know about the uncertainty of stock market investing and my nearly schizophrenic approach of wanting to avoid loss yet participate in gains, there is a risk management strategy that satisfies both my desire for safety and need for potential growth.

Mitigating Market Risk

Most of us would not think twice about whether or not to have insurance on our house. When an insurance company issues a policy they are concerned about things such as potential defective wiring and locks, flammable substances stored in the garage, and anything else that increases the chance of loss. These are called physical hazards. Insurance companies also have to guard against fraudulent claims and dishonesty. This 113increases the chance of loss, and this is called a moral hazard. Insurance will cover specific causes of loss, such as fire and weather-related losses. The cause of loss is referred to as a peril. Even though insurance companies expect a certain number of claims, the percentage is relatively predictable as long as they insure enough geographically diverse residences.

When we purchase homeowners insurance we’ve transferred the risk of loss (for covered perils) to the insurance company. We intentionally retain part of the chance of loss (the deductible in the policy) to make the premium reasonable.

You can’t go to your local insurance agent and expect him or her to write you a policy to cover unexpected losses on your investments. Insurance companies write policies to cover only pure risks, where there is a possibility of loss or no loss. An insurance company will not write a policy for a speculative risk, where there is the possibility of profit or loss. For example, you won’t find an insurance company that offers a policy insuring against the loss of the market value on your home.

Investment risks all come down to uncertainty. If we knew with certainty whether the market was going up, down, or even staying the same, we could make truckloads of money in the market. Most investors gamble that the market will go up, and based on the past, that looks like a reasonable bet. But the market is loaded with hazards that increase uncertainty, thereby increasing our chance of loss. Compare just some of the “hazards” presented in Chapters 2, 3, and 4 to a few hazards associated with owning a home:

• OWNING INVESTMENTS—HAZARDS THAT
• INCREASE CHANCE OF LOSS
  
  
• Fraudulent accounting
• Unethical management
• Bad economy
• Irrational behavior of investors
  
• 114OWNING A HOME—HAZARDS THAT
• INCREASE CHANCE OF LOSS
  
  
• Defective wiring
• Located in flood zone
• Hurricanes
• Oily rags stored next to the furnace

We can reduce the chance of home loss by reducing the controllable hazards. We can correct defective wiring and dispose of those oily rags. We can buy a home that’s not in a flood or hurricane zone. All of these hazards are controllable by us if we choose to avoid them. But what can we do to guard against defective accounting and sleazy management? We can lobby for reform and vote our proxies, but this does nothing to reduce the current risk of owning investments. Conflicts of interest are built into the system. How do we deal with that? As for the irrational behavior of investors, we’ll never be able to figure that one out. And these are only a select few of the many hazards of investing.

Risk Management

So what do we do about market risk? Traditional risk management says there are four things we can do: avoid it, attempt to control or minimize it, retain it, or transfer it.

• AVOIDING RISK
• If we are concerned about a plane crash, we don’t fly.
• If we’re concerned about stock market risk, we don’t invest in stock.
  
  
• CONTROLLING RISK
• If we are concerned about our health, we watch our diet and exercise.
• 115We try to minimize market risk by asset allocation and diversification.
  
  
• RETAINING RISK
• We decide to take the risk that our $50 lawn ornament will be stolen.
• We decide to invest all of our 401(K) in our employer’s stock.
  
  
• TRANSFERRING RISK
• We buy a homeowners policy to transfer our risk of loss by fire to an insurance company.
• We buy a market-linked investment to transfer the risk of loss in the market to the issuer.

Every one of us is a risk manager regardless of how little or how much we own. We don’t just manage our personal tangible assets, including money and investments, but we make daily decisions that affect our health, quality of life, and our life expectancy. Some risks are impossible to transfer. We can’t smoke and eat junk food every day and transfer the increased risk of heart trouble to someone else.

The majority of people with money to invest put a substantial portion into the stock market. The minority choose to deal with stock market risk by complete avoidance. Stock market risk is conventionally dealt with by retention, with an attempt to minimize and control it through diversification, asset allocation, and a long-term outlook. The problems associated with this method of risk management for stocks/mutual funds are well documented and give investors a false sense of security, especially when overall markets are unchanged or increasing as they were in the 1990s. This traditional method of managing risk is unsound. Investors are still gambling with their principal.

But there is an opportunity cost in missing out on the sometimes exceptional gains that investing in the market can provide. The answer to this dilemma is to transfer the risk of being in the market to a third party. When you transfer the risk of loss of your house to a third party you pay a premium, even though you hope you never have to submit a claim. When you transfer the risk of market ups and downs to a third party you continue to hope that the market goes up in the long run, even though you may not receive 100 percent of the increase. The fact that you might not get a return as high as the overall market is the “premium” you pay for the guarantee that you won’t lose the principal of your investment.

If you shop for homeowners coverage with different insurance companies, you may be surprised to find a wide variation in premiums for the same coverage. Some insurance agents represent multiple companies so that they can provide their clients with more competitive rates. By the same token, protected investments are plentiful and provide a broad range of guarantees and benefits. Chapter 9 reviews some of the types of protected investments that are available today.