Risk: How fast can you go?
Marcio Silveira, CFA® , CFP®
If you are like me, when you need to go somewhere farther than one mile, you drive. We have a certain level of control over how fast we drive. This control is particularly salient in country roads and highways. The faster we choose to drive, the sooner we get to our destination. This upside comes with a downside, however. The quicker we go, we start to run into several risk factors. We risk missing a turn or exit, we risk violating traffic laws and regulations, and we risk getting into an accident. When we drive really fast, these risks are further magnified.
The same argument can be made about investments. The more aggressive the portfolio is, the higher it is the potential for a meaningful return. It must be this way in a free market economy. Investments with low risk and high rewards are quickly driven out of existence by competition. So, for any investor with a practical time horizon, higher returns are associated with higher risk. Risk in investing can take many forms. Here are a few manifestations: purchasing power (inflation), credit (not being paid back), liquidity (not being able to access your money), market risk (ups and downs in the securities market). All these forms of risk are important considerations, but the chances of losing money because of market moves are often the most visible.
There are clear parallels between driving speeds and market risk. Assuming these risks can allow you to get you to your destination quicker, they also expose you to potentially very negative consequences. The decision of what speed to drive and how much market risk exposure one should have in a portfolio is not that different, but until recently, the numbers to express them were very different. Investors could really benefit from a system that would measure risk on a scale of 0 to 100. This scale is the one that drivers have in miles per hour.
Traditionally, market risk has been measured in standard deviations of returns. The most common unit of time to measure returns is daily, and then they can be annualized with a simple statistical procedure. The vast majority of investors have a difficult time understanding this concept of standard deviation. If you don’t remember your introductory statistics class, here is the formula:
It is certainly not very intuitive… (if you would like to learn more about it, please reach out). Is a portfolio annual standard deviation of 25% high or low? It is hard to tell intuitively. It would be a lot better to have numbers that we can more easily relate to. We here at Toler Financial Group use a system that converts risk to a number between 0 and 100. We can clearly communicate to an investor that a risk number of 25 is quite conservative, and 80 is quite aggressive. When you are driving on a highway, and you are one mile from your exit, you should reduce your speed from the 70s or 60s to the 40s or 30s, right? The same is true for investments. If you need to pay for college tuition in one year, you should not have investments with a risk number of 80. Our system converts the hard to understand standard deviation into the easy to understand risk number.
When you exit your investments is an important consideration, but it is not the only one. The investor attitude toward risk is also very relevant. I had a chance to live for a few months in Germany. There the freeways have certain portions with no speed limit – Die Autobahn – and some drivers go really fast. I have seen drivers going faster than 150 mph. I never had the inclination to drive that fast. Maybe because I have little kids… In any case, my tolerance for speed was never enough to let me drive faster than 100 mph. The same goes for the willingness to bear the risk. If someone does not tolerate much portfolio fluctuation, the investments should be adjusted accordingly, and a thorough education process must take place before any significant investment risk is assumed.
The place to start is to know what is your risk number. Do you know yours? If you don’t, reach out to us so we can start a conversation.
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Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Toler Financial Group and Cambridge are not affiliated.