Risk tolerance or loss tolerance?

Risk tolerance or loss tolerance?

When investors hear the term risk, their thoughts turn to losing money.  Ironically, the financial services industry and academics define investment risk as the volatility of prices.  Volatility measures how far prices move above and below an expected level.

Investors, however, care little about volatility but are passionate about losing money.  Oak Wealth Advisors believes we should be implementing strategies to minimize losses, not simply engineering portfolios to have less movement.

As the following chart shows, the stock market declined about 50% from late 2007 through March 9, 2009.  It has since rebounded close to 100% from the bottom established in March of 2009.   

In terms of volatility, 2009-2011 has been every bit as volatile as 2007-2009 was.  According to the financial service industry’s definition, risk-averse investors should have been just as uncomfortable during 2009-2011 as they were from 2007-2009.  The reality is that people grew terrified of the investment markets during the 2007-2009 recession, and have been pleasantly surprised by the rise in the markets since early 2009.  Unfortunately, the financial services industry has accepted a non-useful model for the assessment of investment risk.

During the recent recession, additional attention was given to financial risks.  Nassim Taleb wrote the book The Black Swan in which he illustrates the significant impacts of highly improbable events.  While his commonly cited work has led to a greater awareness of the impacts of the unpredictable, neither he nor anyone else has developed a model to more accurately forecast catastrophic events.

Oak Wealth believes that investment advisors should focus on minimizing the risks that can lead to catastrophic losses for investors.  While it is impossible to eliminate the risks, there are strategies that can minimize the damage they can inflict.  

DIVERSIFICATION

Modern portfolio theory provides the greatest financial “free lunch” available.  It is as simple as increasing diversification in an investment portfolio.  By adding investments that are not perfectly correlated with the other holdings in the the portfolio, we can achieve greater returns with less risk.  Increasing diversification is one risk minimization strategy available to all investors. 

Diversification does not eliminate the risk of loss, but it does allow an investor to optimize how much return can be expected from each unit of risk (standard deviation) the investor is willing to accept.  The example on the prior page illustrates that adding five additional asset classes to an existing porfolio of stocks and bonds will generate a higher expected return, (7.92% vs. 6.86%),  and less portfolio volatility or risk, (9.99 vs. 11.12).

LIQUIDITY

Liquidity is another component of risk management that received significant attention during the recession.  As a general rule, most people should keep three to six months of living expenses in a savings or money market account.  The goal is to eliminate the risk that you will have to sell an investment at an inopportune time to pay for a current financial obligation.  For some people who had the majority of their wealth tied up in illiquid investments like real estate, hedge funds, or private businesses, the recession was even more painful as they did not have the ability to escape from falling prices without incurring a significant cost to liquidate their holdings.   Investments in mutual funds, exchange traded funds, and individual stocks are examples of liquid investments because they can quickly and efficiently be sold for cash.   

HUMAN CAPITAL

Risks associated with human capital also should be evaluated.  For a young family with two employed parents, the value of their human capital relative to their investment capital is high.  For a couple in this position, or even a single person with a high paying job, their careers and their savings will have the largest impacts on their future wealth.  In general, they can afford to take more investment risk with their financial assets.  If their future wealth is linked to their company’s stock price, special consideration needs to be given to decrease exposure to the company and the industry in the financial investments held by the individual.  Examples of this type of human capital risk include executives with large stock option grants and employees whose 401(k) accounts hold significant shares of the company’s stock. 

At the other end of the human capital spectrum are retired individuals and couples who have expended their human capital during their working years.  Many may only have government programs like Social Security to supplement the cash flows from their portfolio.  For them, the level of investment risk should be lower since they do not have the ability to compensate for market losses with new savings from earnings.  The one caveat to these general recommendations is that some retirees must accept more investment risk due to the need to earn higher returns from their investment portfolio to cover their living expenses in retirement.

LEVERAGE

Leverage is another component of financial risk management.  While leverage has taken on a far more negative connotation in recent years, it has been one the biggest enablers of wealth creation throughout history.  Sadly, it has also been responsible for the destruction of a significant amount of wealth.  The most commonly used form of leverage is the home mortgage.  Very few people can afford to pay cash for their homes at the time of purchase and will typically put down 20% of the value and borrow the other 80%.  While it allows you to enjoy a much nicer home than you could have purchased using only your available cash, it also creates the risk that if you fail to make your mortgage payments (or tax payments) you can lose the entire investment you have in your home. 

Sometimes greed leads investors to over-indulge in the use of leverage.  Through leverage, you can multiply your investment returns or drive yourself quickly into bankruptcy.  As we have seen in the recent mortgage crisis in the United States, people took advantage of easy financing and employed far more leverage than they should have.  The results are ugly.  Just as we would not recommend 20 times leverage on a mortgage, as would be the case with a 5% down payment, we also feel it is imprudent to leverage financial investments.  While there is an opportunity for greater earnings, significant leverage exposes you to catastrophic losses.

INSURANCE

The most obvious form of risk protection is insurance.  Homes, cars and other valuables should be covered from losses.  In reviewing coverages, the need to purchase policy riders at an additional cost to cover flooding, earthquakes, or other natural disasters is often discovered.  Every homeowner needs to consider the likelihood and ramifications of a loss versus the cost of covering the loss.

Portfolio insurance can also be evaluated.  In its simplest form, portfolio insurance is created by purchasing stock options that will provide a payoff if the market declines enough in value.  The concept is very similar to insuring physical property.  You pay a premium in the form of the option purchase price and you only receive a payoff if the negative market movement occurs.  Due to the costs involved, the purchase of stock options for portfolio insurance is usually done only in circumstances when investors are highly loss averse and want to mitigate their risk for a specified period of time.  Option prices are correlated with the volatility of the stock market and the consensus sentiment about the direction of the market.  This correlation means that options are most expensive at the times when investors are most likely to be seeking protection.  

One of the best uses of stock options as portfolio insurance is to offset the risk in a portfolio from a large single stock position.  Unfortunately, in many cases, significant stock concentrations are held by corporate executives who are prohibited from purchasing options to offset their risk.  

CONCLUSIONS

Risk is unavoidable.  Most significant losses, however, are preventable. 

Everyone should take a holistic view at their risks and reduce or eliminate the ones that have the greatest likelihoods of delivering large financial setbacks.  Prudent portfolio management is one step in this process.  Additional steps are required to implement a comprehensive reduction in risk and greater financial security.

This update is intended for the use of Oak Wealth Advisors LLC clients. This update should not be viewed as personalized investment or financial planning advice from Oak Wealth Advisors LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their individual situation, they are encouraged to consult Oak Wealth Advisors LLC. Past performance does not guarantee future results and all investments should be scrutinized before being implemented in a portfolio.