Solving The Wrong Problem

Jun 13, 2018 | Investment Committee


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But, as warren Buffett has pointed out on more than one occasion, this conventional definition of risk taught in business schools, and how risk is normally measured in a portfolio – is wrong. Volatility and risk are two different and important issues

We all work very hard for our money, and even harder to put some aside into a nest egg for the future.

Because savings are so hard to come by, we are all more than justified in worrying about what risks are being taken when it comes to choosing an investment portfolio.

 

Risk is normally defined as volatility, or, in other words, how much a portfolio can go up and down in a particular time period. If we accept this definition of risk, then the objective for risk management becomes minimizing the fluctuations in a portfolio.

 

But, as warren Buffett has pointed out on more than one occasion, this conventional definition of risk taught in business schools, and how risk is normally measured in a portfolio – is wrong. Volatility and risk are two different and important issues. Mr. Buffett has a more nuanced definition of risk. His definition of risk centres around the chances of losing your purchasing power over time.

 

There is quite a long walk between volatility and Buffett’s risk definition. By the purchasing power measure – you could conceivably have a portfolio that has very little volatility, yet a high degree of risk if it fails to keep up with inflation because of low returns, taxes or permanent losses.

 

Part of the challenge is that we are all human and what is immediately in front of us, namely volatility, is what we’re likely to worry about. We are also hard-wired to avoid danger; it’s an instinct that kept us alive when we had to outrun predators. So a sudden drop in a precious portfolio is a hard grab on our attention. We don’t have any comparable instinct that makes us scared if we don’t grasp opportunity. Volatility is genuinely scary.

 

For these reasons, many investors are solving the volatility problem without giving the same attention to the purchasing power problem. Yet since you get paid, over time, for accepting volatility – you may very well be solving the wrong problem. Fixing volatility might mean accepting both lower returns and taking on the risk of declining purchasing power.

 

When it comes to the stock market, the majority of the news stories we read or hear are about the chances of an impending market drop, crash or correction. These stories are more likely to grab our attention. Yet when we look at stock market data over the long term, we see that there are positive years 75% of the time and negative returns 25% of the time, approximately.

 

Working hard to avoid market declines is a much tougher task than working to capture the positive years since you have considerable odds stacked against you. Yet investors tend to worry much more about corrections than they do about the risk of not being invested.

 

We certainly wouldn’t suggest that you can’t suffer permanent losses in the stock market. Companies go out of business every day, and having all your eggs in one or two baskets is a bet that isn’t generally worth taking. There are stocks in particular sectors that will catch fire and rise to speculative and unsustainable heights, and these stocks can cause permanent loss when they return to earth.

 

But investing in one company or speculating is different from investing in the market. A market portfolio is spread across sectors and countries, and carries a valuation that is within reason. A market portfolio will give you about 75% positive years, 25% nasty surprises and a return that is a multiple of other asset classes. All because you get paid for the volatility.

 

A stock market portfolio is a solution to that risk defined by Buffett. We mostly need to worry about purchasing power over time. Solving the volatility problem is important is certain circumstances, but it belongs behind the risk of not keeping up with inflation.

 

In our practice, we have year-by-year financial plans for our clients that can help put risks into perspective. The great thing about a plan that projects forward for 25 or 30 years is that issues like purchasing power come into bright focus. A $100,000 income today might need to be $250,000 by the end of the planning horizon.

 

A good plan can make it obvious why a higher return is required. It can also become easier to accept volatility when you know the only way to stay in your home or continue to travel through retirement is to get a higher return by accepting some volatility.

A plan will help to solve the right problem.