Section 5.3

Fundamentals of Market Investing by Adam J. McKee

Measuring Risk

For most of us, the risk in our portfolios is reminiscent of what Justice Potter Stewart said of pornography in a now famous 1964 United States Supreme Court case: “I shall not today attempt further to define the kinds of material I understand to be embraced… but I know it when I see it …” Unlike the learned Justice, I do not pretend to know risk when I see it.  In the right market, all investments may seem safe, but risk always lurks below the surface.

Risk is what we social scientists call a “latent construct” because it is multidimensional (composed of many varied factors) and thus cannot be directly observed.  To make matters worse, even experts do not agree on the conceptual definition of risk.  To escape Justice Stewart’s problem and have a real grasp of the risks we face in our portfolios, we need to define the concept so that we can measure it (for you social scientists, we must be able to operationalize it).

As any good social scientist can tell you, the results of data analysis and statistical findings are only as good as the quality of the data going into the analysis.  As computer scientists are fond of saying, “garbage in, garbage out.”  We researchers use the term validity to mean that a measurement is measuring what it is supposed to measure.  When practitioners want to measure something, they often go with data that is handy and pay far less attention than they should to validity.  You may end up measuring only a single factor of a complex construct like risk, or you may not be measuring it at all.

As I mentioned earlier, individual investors tend to view risk as a potential negative impact on their bottom line.  If something potentially causes you to lose money, then it is risky.  This concept is closely related to the investor’s timeline.  If you are looking to invest for 35 years and genuinely can ignore day-to-day price movements, then you can follow Mr. Buffet’s wise advice and simply buy and hold a stock index.  As you close in on retirement and need a portion of your portfolio to live on, the equation changes.  This change means that a reallocation of your assets is likely necessary because you need to take off risk and the short term matters.  Writers like me, financial advisors, and academics all want to help you out with this process by providing formulaic strategies that tell you what proportions of what assets to hold and when in your life you should hold them.

I am guilty of this along with a million or so other writers, but I will warn you that these (you’ll find mine in the final section of this book) are merely examples and meant to serve as a template that you must modify to fit your psychology and portfolio value and needs.  The value of your portfolio in relation to your investment strategy is often overlooked.  Many investors feel that once you retire, you take everything out of risky investments and put it in completely safe investments such as treasury bonds or annuities.  Many people are lured into annuities for that very reason; they want to be prudent and safe and don’t consider the high cost of safety that may or may not be necessary.  As I have argued elsewhere, excessive prudence can be the riskiest investment decision of all.

When it comes to the risk analysis strategies used by Wall Street professionals, you may not agree with their assessments.  These folks have some pretty unfair demands placed on them in terms of performance.  They need to limit their down days as much as possible to keep panicked clients from selling off investments and switching brokers.  This seeming obsession with short-term performance can be very detrimental to long-term growth, and investors that understand this can weather the storm without taking action.

Sadly, human psychology wires us to do what is the opposite of our best interest.  We get into the markets during periods of euphoria.  We exit the markets in times of panic.  This means that we buy high and sell low, an ancient and well-tested strategy for losing money.  When allocating your own portfolio, you must include some objective soul searching.  Everyone is brave in a bull market, but when things get ugly, what kind of investor will you be?  Your mental health may require that you invest in a portfolio that has less risk and more predictable returns than a strategy that hopes to capitalize on outsized years in the stock market.

In the final chapter if this book, I’ll suggest a portfolio that matches the return of equities over a long term when backtested.  As I am now mid-career and my nest egg has built up some momentum, I do not feel the need to take on the risk that I once did, and this is the portfolio allocation I use.  I also keep a small “mad money” account to get my gambling urges out of my system.  In my personal investing, I have found that the hardest thing to master is myself.  I am prone to do rash things based on convictions that have no empirical basis.  I now structure my investments in such a way that I cannot do too much damage.  To develop your own strategy, you will need to study the various risk management strategies and get a firm grasp of what is possible.  Perhaps the most sensible approach is found in what is known as Modern Portfolio Theory.  Even if you disagree with the strategy in general, you can learn much about how risk is conceived and measured from studying it.

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Last Updated: 6/25/2018

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