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Risky Business

Adam M. Grossman

OPEN A FINANCE textbook, and you’ll find discussions of volatility and beta, value-at-risk, the Sharpe ratio, the Sortino ratio, the Treynor ratio and many other quantitative tools for measuring risk. But what should you make of these metrics? Are they an effective way to control risk in your portfolio?

These tools do have decades of research behind them, and they can be useful. But I believe they’re also incomplete. Worse yet, they can be misleading. William Sharpe, winner of the Nobel Memorial Prize in Economic Sciences, once commented that his ratio was being “manipulated” by investment marketers “to misrepresent their performance.”

This highlights the first weakness of these quantitative measures: They’re formula-based and that gives them the appearance of being objective, but many of the inputs to these formulas are actually quite subjective. So subjective, in fact, that Sharpe has said, “I could think of a way to have an infinite Sharpe ratio.” To put that in context, a Sharpe value of more than two would be considered very attractive.

Another issue with quantitative measures is that risk is multidimensional. Consider the recent failure of Silicon Valley Bank. None of the quantitative measures referenced above would have detected the risk that ultimately brought down the bank. That’s because, in the end, the bank’s undoing had more to do with psychology than numbers. Depositors began to worry about the bank’s solvency, and those worries caused others to worry. Author Morgan Housel compared it to a stampede: A concern which, at first, was reasonable began to take on a life of its own, driving people over the line into irrational behavior.

The message I take from this: Risk is a bit like a hydra, the creature from mythology that had multiple heads. It’s awfully hard to pin down and even harder to quantify. Sometimes, situations that didn’t appear to carry any risk will suddenly experience a flare up. Other times, existing risks will present themselves in new ways and with a greater level of ferocity.

That’s what we saw in 2020, when COVID-19 emerged. There had been other virus outbreaks in recent years, including other coronaviruses. For several years leading up to 2020, in fact, the State Department had specifically called out the risk of a pandemic.

Here’s what intelligence analysts wrote in 2019, a year before COVID hit: “We assess that the United States and the world will remain vulnerable to the next flu pandemic or large-scale outbreak of a contagious disease that could lead to massive rates of death and disability, severely affect the world economy, strain international resources, and increase calls on the United States for support.”

That was hardly the only warning. But if a pandemic had been on our radar, why were we so unprepared? That gets at another reality of different risks: It’s hard to know when to take them seriously. If a particular risk hasn’t been seen before—or hasn’t been seen in a long time—it’s difficult to know how to think about it. How do we distinguish between risks that are real and those that are just paranoid notions?

Indeed, those who dwell too much on prospective risks face a risk themselves: They’ll be dismissed as worrywarts. Investor Nouriel Roubini, for example, has earned the nickname Dr. Doom for his perpetually glass-half-empty outlook. He’s a serious economist, but many people roll their eyes when he delivers yet another downbeat forecast.

Investor William Bernstein, in his book Deep Risk, discusses “the four horsemen” of portfolio risk. In addition to inflation and deflation, which are common concerns, he includes devastation and confiscation—the sorts of things that would be associated with a breakdown of civil society. Are these real risks? I wouldn’t dismiss them—and I credit Bernstein for being brave enough to raise these questions—but it’s also difficult to know what reasonable steps you might take to protect yourself against them.

Risk is tricky also because it’s a master of disguise. Even when we have a good understanding of a particular risk—such as market bubbles—we can still be fooled. Not unlike viruses, market bubbles mutate. They always come back looking a little different each time. That allows them to slip through our defenses. That, in fact, is how I would characterize much of what happened in 2021, when all sorts of newfangled investments rose to prominence—SPACs, for example, and thousands of new crypto “currencies.”

Even today, despite cryptocurrencies’ volatile performance and lack of intrinsic value, I know many reasonable people who believe they’re valid investments. Are they wrong? I think so. But we won’t really know until we have the benefit of hindsight. And that’s the problem. Investment bubbles are indeed masters of disguise.

Given these challenges, what can you do to manage risk? Below are some suggestions.

For starters, don’t rely on any single measure of risk. In his book, Margin of Safety, hedge fund manager Seth Klarman wrote, “Risk simply cannot be described by a single number.” At the same time, though, I don’t view these quantitative risk measures as worthless. They each can help in their own way, but only as part of a mosaic.

In Against the Gods, the late Peter Bernstein addressed this topic. Share price volatility is a common yardstick for measuring risk, but it’s also been roundly criticized. Klarman put it plainly: “I find it preposterous that a single number could be thought to completely describe the risk in a security.” But Bernstein argues that volatility is a measure that’s good enough, even if it’s not perfect. “Statistical analysis confirms what intuition suggests: most of the time, an increase in volatility is associated with a decline in the price of an asset.” In other words, a risk measure doesn’t need to be perfect for it to be useful.

Next, use history to your advantage. Indeed, market downturns do carry a silver lining: They help us better understand the character of risk. What have we learned from the current cycle? In my view, it serves as a reminder that risks may recede but never go away entirely. Inflation, which had been dormant for 20 years, is a good example. For that reason, in making a financial plan, it’s important not to dismiss any particular risk because it hasn’t happened recently. Everything has some probability, even if it’s low.

What else can you do? Recognize that risk is personal. In fact, an event that might be bad for one person might be positive for someone else. For instance, if you’re in your working years and regularly adding to your savings, stock market downturns are actually positive events. I always tell younger investors that they should be hoping for a downturn because that’ll allow them to acquire shares at lower prices. Meanwhile, lower prices are the opposite of what retirees want to see.

Recognize also that some risks aren’t necessarily all good or all bad. Some market events are positive in some ways but negative in others. If you’re in retirement, for example, stock market downturns are generally negative. But suppose you’re looking to complete a Roth conversion or trying to move assets to the next generation in your family. In these cases, you’d benefit from a recession and lower asset prices.

Finally, try to maintain what I’ve called a “five minds” approach to investing. In evaluating risk, employ simultaneously the mindset of an optimist, a pessimist, an analyst, an economist and a psychologist. This balanced approach can help you navigate the landscape of risk.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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