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PEOPLE DEBATE JUST about everything in personal finance. Among these arguments: how best to measure risk. Partisans on this topic tend to fall into one of two camps.
In the first group are those who believe risk can be distilled down to a single number. For these folks, the most common numerical yardstick is portfolio volatility—that is, the degree to which a portfolio’s price bounces around from year to year. Portfolios exhibiting lower volatility are deemed safer.
On the argument’s other side are those who believe it’s misleading to summarize risk with a single number. That’s because volatility can mean different things in different situations. When a stock declines rapidly, that’s called downside volatility, and no investor welcomes that.
But there’s also upside volatility—when a stock has risen rapidly. Take a highflying stock like Apple or Amazon. Because their prices have risen much faster than the overall market, they too have exhibited above-average volatility. According to textbook theory, they’re very risky. But they’ve also been very profitable. It’s for this reason that many view volatility on its own as a less-than-perfect tool for investors.
Another problem with quantitative measures of risk: They ignore the human element. Consider a portfolio with 15% average volatility. Is that good? It’s hard to say because no portfolio exists in a vacuum. Rather, portfolios belong to people or to institutions, and every individual and every committee is different.
It’s for these reasons that I’m wary of quantitative measures. Risk, in my view, is multifaceted and, to a great degree, personal. That said, if risk can’t be measured quantitatively, how can it be measured? This is admittedly difficult. That’s why I suggest that we not worry so much about measuring risk and instead put more focus on managing it. To that end, below is a brief risk-management playbook.
Early years. If you don’t yet have significant savings, risk management might not seem like a concern. But it is. During these early years, it just takes a different form.
As we move through life, we have, in a sense, two account balances. First is the traditional type of balance—what we have in financial assets. The second type of balance is what’s known as human capital. This refers to our future earning potential. Over time, as we log more years in the workforce, our human capital will decline. But at the same time, our financial capital should increase.
If you’re early in your career, the most important thing you can do is protect your human capital. What does this mean in practice? The key is disability insurance and, if you have a spouse or children, life insurance. While not inexpensive, these two types of coverage can help protect your human capital during the early years.
Working years. Over time, insurance will still be important. But as you build up savings, you’ll want to take steps to protect your financial assets as well. How? The key lever here is asset allocation. Because the stock market can be erratic, investors need to maintain enough outside of stocks—and in cash or bonds—to carry them through future market downturns.
If you’re a net saver, though, you might question whether this is even necessary. Indeed, it’s a question many people ask: If I’m adding to my savings and not withdrawing, why not invest every dollar in stocks to maximize growth? That certainly has intuitive appeal, but there are two reasons you might opt to be a bit more conservative.
You may have heard the term “black swan.” Popularized by a book of the same name, a black swan is an event that’s completely unexpected. The term’s origin is helpful in appreciating its meaning. In many parts of the world, including Europe, all swans are white, so historically it was always assumed that swans everywhere were white.
But in the 1600s, when Dutch explorers landed in Australia and found that black swans were prevalent, they learned a lesson, one that’s applicable to personal finance: We should be careful not to dismiss possibilities—or risks—just because we’ve never seen them before. The risk of a “black swan” event is the first reason you might choose to be more conservative with your portfolio during your working years, even when you have no specific need to draw on your savings.
What does this mean in practice? For younger families, I don’t normally recommend a traditional portfolio with specific percentages in stocks and in bonds. Rather, I recommend deciding on a specific amount of cash and simply holding that at all times to guard against a potential black swan.
There’s another reason you might consider holding a cash buffer like this. The psychologist Daniel Kahneman, who recently died, jointly developed an idea called prospect theory. In short, Kahneman and his colleague were the first to recognize that people dislike losses disproportionately more than they enjoy gains. Since bonds can moderate losses when the stock market falls, this is a second reason you might want to hold some savings outside stocks even when it doesn’t seem necessary.
To be sure, asset allocation should never be our only focus. Other priorities include managing taxes, keeping costs low and avoiding complexity. But I see these as secondary. During the arc of your working years, the stock market will likely go through multiple cycles. If your portfolio is structured so these ups and downs impact you less, that, I believe, is the most important thing.
Retirement. As you approach retirement, risk management takes a different form. At this stage, you’ll likely no longer need life and disability coverage. Instead, managing portfolio risk will be paramount. This is a topic I’ve addressed before. But in short, to arrive at an appropriate portfolio structure, I suggest asking these three questions:
There’s a fly in the ointment: If you work through those questions, I suspect you’ll find there isn’t just one answer. For most people, there’s a range of asset allocations that can make sense. How can you settle on an answer? Psychologist Gerd Gigerenzer has spent his career studying risk and decision-making, and suggests an approach he calls “fast and frugal.”
His advice: Avoid trying to over-engineer an answer. Because the stock market is inherently unpredictable, greater and greater levels of analysis may only make us more confident in conclusions that are still ultimately just guesses. As a result, counterintuitively, trying too hard to reduce risk can actually result in greater risk. Gigerenzer cites the collapse of the hedge fund firm Long-Term Capital Management as an example of this phenomenon.
The bottom line: As long as you’ve given a good amount of thought to the three questions outlined above and favor an asset allocation that’s in the appropriate range, you shouldn’t worry any further. As the English philosopher Carveth Read once wrote, “It is better to be roughly right than precisely wrong.”
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 X @AdamMGrossman and on Threads, and check out his earlier articles.
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Great Article Adam…as always.
My equity portfolio is at Vanguard. They have four ETFs…Total US Stock Market, Total International Stock Market, Total US Bond Market and Total International Bond Market.
Within these four ETFs are all the companies in the US and outside of the US. With these four ETFs, the only decision you need to make is what percentage of each is best for your situation.
As your age and family situation change over your lifetime, you make changes in the percentages of each ETF held in your portfolio, in accordance with the answers to your three questions:
One additional consideration regarding risk. “When you have won the game, stand up, scoop up your chips, and walk away.” Or in other words,
In anticipation of retirement in January 2024, in June 2023 I made the decision to move my bond portfolio out of ETFs and into Fixed Indexed Annuities with Income Riders. These FIAs are earning 8,25% guaranteed, within the income accounts of the various FIAs, each year they remain deferred. These FIAs were purchased with Roth Dollars, so when I decide to “turn on the income streams,” the income will be income tax free, and will nor effect my Social Security Taxes or my Medicare/IRMMA costs.
Did I possible give up some potential returns by taking the money out of the market? Yes. Did I benefit by so doing, knowing I now have guaranteed income streams as long as with my wife or I live. Also Yes.
Is it the right answer for others? I have no idea, but it was the right answer for us, since now we are assured that we can increase our guaranteed income by starting income streams from the different FIAs, when we choose to. This approach will help address a number of retirement risks, including Longevity, Inflation, Market, and a few others.
Our Equity portfolio serves as our longterm care fund (for my wife, I have LTCi,) our legacy to our two children, and additional funds for lifestyle, if desired. We are blessed that our expenses are only 90% of our Social Security benefits, as we are debt free. Lastly, we have 2.5 years of expenses in cash.
Sometimes we overcomplicate issues, like risk. By being academics and studying risk intellectually, we simply ignore what we normally call gut reactions. To me, risk is what keeps you from sleeping well at night, and I decided some time ago that although volatility is the price you pay for additional returns over time, I prefer the SWAN Approach…sleeping well at night.
Hopefully the SWAN approach can be implemented by others with their answers to the risk questions.