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Craig Allen: In Rethinking Risk, the Risk of Being in the Market Outweighs the Risk of Being Out

As an investment management professional for the past 23 years, one of the things I struggle with most is managing client expectations. For most investors, the concept of risk has been molded over many years. Misperceptions, primarily forced upon investors by so-called investment professionals, have resulted in a comprehensive misunderstanding of risk and of how investors should make their decisions in the context of the true risk in the market.

First, let’s address what risk should mean to regular investors — individual investors who are investing their own money, as opposed to professional investors investing the assets of others or of institutions, corporations, etc. For regular folks, the risk that matters is the risk of losing money. While this may seem like common sense, this is not how industry professionals see or, more important, measure risk. Professionals see risk as volatility and typically measure it in the same way, regardless of whether the risk is of making money or losing money. To put it more simply, consider this example: the risk of the market going up by 5 percent is measured exactly the same as the risk of the market going down by 5 percent.

I know that sounds absurd, and for regular investors, it is. But this is exactly how risk is measured by professionals. Obviously, this doesn’t make sense for regular investors, who again are really only concerned with the risk of losing money. For these investors, it does not make sense for an industry professional to manage their assets in the context of risk measured by standard volatility measures — standard deviation from a mean return (standard deviation is a statistical calculation based on the amount that the return of an asset or portfolio deviates from the average return that the asset or portfolio has generated over some period of time).

To add a little detail, let’s assume a portfolio falls in value from $1 million to $900,000, or by $100,000. This would represent a 10 percent decline ($100,000/$1 million = 10 percent). To get back to even, the portfolio would have to increase in value by $100,000. The problem is that the portfolio is only worth $900,000 (not $1 million), so the portfolio would actually need to grow by 11.1% ($100,000/$900,000 = 11.1 percent). As can be seen from this simple calculation, once money is lost, the portfolio must grow by a larger percentage just to get back to even. The math works against us!

From this simple example we can clearly see that avoiding losses is much more important than achieving gains. It follows (and the math bears this out) that avoiding large losses is even more important than achieving large gains, with the importance of avoiding increasingly large losses increasing as the size of the potential loss increases.

OK, assuming I have not confused you completely, my point is that there is a disconnect between the way that industry professionals define risk and the way individual investors should define risk. This has some powerful and frightening implications! If professionals are investing assets with an incorrect definition and understanding of the appropriate risk for the investor, then the portfolio, by definition, is misallocated — the amount of risk the investor is taking is not appropriate. If this is the case, it follows that the chances of the investor achieving his or her stated objectives are not good and in some cases might be nonexistent! If the allocation of assets is incorrect, the investors will own assets they should not own and may not own other assets that they should own.

The moral to this story is that investors should not assume that their investment adviser understands the true risk that is appropriate for their portfolios. While it would be nice if the investor could assume that all professionals understand risk, the reality is that they do not. As a result, it is the investor’s responsibility to understand his or her own risk tolerance, and to convey this information to the investment professional.

It follows from our discussion that since losing money is more risky that making money, for the individual investor it is more important to avoid losses rather than to make profits. If this is the case (and I am stating here emphatically that it is), then it is more important to be out of the market when the market is going down than it is to be in the market when the market is going up. This is an important revelation! It means the entire concept of buy and hold must be thrown out!

I realize this will come as a shock to many. After all, the investment industry has been telling investors for decades that it is impossible to time the market, so the only logical investment approach has to be staying invested all the time. The problem with this conclusion is, again, the way in which risk is calculated. If we place more value on avoiding losses, buy and hold strategies no longer appear to be the best approach.

I have been employing a strategy that includes raising significant cash positions and holding that cash for extended periods of time, like right now, when I do not like the current market conditions. It has been a struggle with some clients who have been conditioned to believe that they should remain 100 percent invested at all times, regardless of market conditions. But if we understand the correct definition of risk, as outlined above, we can begin to rethink the basic fundamentals of investing that investors have been taught for years, to arrive at a new understanding of risk, and of effective investing.

While every investor will have a unique set of investment objectives and an associated risk tolerance, it is beneficial to every investor to properly understand risk as defined in a way that best represents his or her personal interests. By better understanding risk, investors can make more informed decisions about their investments and the professionals they hire to invest their assets.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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