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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.
Over time, as we log more years in the workforce, our human capital will decline.
Actually, for a good portion of our careers our human capital, especially our firm-specific human capital, will increase due to the knowledge and skills we learn on the job.
Somehow I cannot accept this notion that volatility is indicator of risk or that volatile stocks are riskier. For me, risk is the probability or likelihood of losing the investment.
There are only 4 options in managing any risk.
1. Avoid (e.g. if you are afraid of car accident, do not drive.)
2. Reduce (use public transportation)
3. Transfer (buy insurance policy)
4. Accept (driving at night is risky, but you accept the risk and drive).
Same logic will apply to any other risk.
Having taught Principles of Insurance Planning for 15 years, I will testify that YOU are 100% correct.
Avoid…Reduce…Transfer…Accept.
There are no other options.
That’s an interesting framework, thank you.
I had some early training in mathematical models, although it did not become my career. I agree that risk can mean many things. For me, volatility does not seem the same thing at all, so I find it puzzling that so many in the investment world equate risk with volatility. My puzzling changes absolutely nothing, of course, about how others see the world.
Let me give you an example from my own portfolio. Suppose I use Graham/Buffett et al to select 25 stocks based on their fundamentals. Obviously I believe those stocks as a group would also be less risky than owning the whole market–but measures of volatility will disagree.
I believe volatility is defined as variance from the market as a whole. If the total market goes up more than this group of stocks, that makes this group of 25 more volatile. If the total market goes down more than this group of stocks, that also makes this group of 25 more volatile. Yet somehow in my mind they are still identifiable as less risky. So I would say they are indeed more volatile (in failing to track the total market) and less risky (since each of them takes less risk than the average stock in the market in fundamental ways.)
Thanks, Steve, for your thoughts on this. I agree that risk is an awfully difficult concept to even define. If you haven’t read it, I definitely recommend Howard Marks’s “The Most Important Thing,” which dives deep on this topic.
Great job explaining “risk” and the need to manage it, rather than unrealistically trying to eliminate it. To mitigate sequence of returns risk for those already retired, you, Jonathan and others suggest holding enough in cash and short term assets to provide for withdrawals until the market recovers. You have suggested 5-7 years worth, some experts much more. I tend to favor holding 10 years or more when the market is high priced as it is now, but if there were a significant correction and prices fell toward more “normal” levels, I might consider 5 years sufficient. What do you think?
Thanks for the comment, Jack. There are many viable and legitimate methods of managing cash flow in retirement, and I’m a big believer in using whatever approach helps you achieve your desired lifestyle AND sleep at night. Essentially, you’re proposing a version of the Bucket Approach to retirement income planning, where savings are segmented into three categories: short-, medium-, and long-term, where the short-term bucket is invested in low-risk assets, like bonds, term-certain annuities, and/or other liquid or cash positions with the aim of funding anywhere from 1 to 10 years of expenses. Where someone chooses to be along that spectrum depends on the retiree’s risk tolerance. One thing to keep in mind is that a little bit of a buffer can’t hurt. For example, if we think we have five years of withdrawals set aside, that might end up being insufficient if our expenses ended up being higher than expected.
Thanks.
Great points, Adam.
“We now return you to our regular programming.” Thank goodness! It is early days in the AI realm and it was an interesting experiment here but, in my opinion, the content was useless. Perhaps a better fit for a startup site – “dumbledollar”.
Thanks for the kind words. I agree that we are in the infancy of AI. Maybe HumbleDollar will run this experiment every year so we can see how it evolves. I suspect it will continue to improve.
Definitely agree that using standard deviation to define risk is suboptimal.
Thanks, and I agree. The risks we face also evolve as we age. As we move into retirement, one of the biggest is longevity risk—that is, the risk of outliving our savings. Risk, in other words, is a moving target.
So happy to see a human byline again, thanks Jonathan!
And what better way to return to HD normalcy than with an interesting AG piece? Thanks, Adam.
Long tail “black swan” events over the past century have happened more often than random chance. It’s why I keep virtually all risk out of the bond part of our retirement portfolio. My favorite definition of risk is Antti Ilmanen’s: bad returns in bad times.
Thanks, David. I think that Black Swans are, by definition, random, but they happen frequently enough that we all need to expect that they will arrive far more frequently than we’d like. I don’t have it in front of me, but there’s a great footnote in When Genius Failed that explains that the risk that took down Long-Term Capital should have happened in something like once every billion years.
Bernstein on pg. 85 in the second edition of “The Four Pillars of Investing” explained this well for the average investor. This was a “20 sigma event”, supposed to only happen once in 10^89 days. Yet it did. Extremely rare tail events do not follow a gaussian distribution, whereas a power law plot is more useful. It happened once in 22,881 days (1926-2012) which was 0.0044%. Still rare, but no longer seems impossibly rare.
My career was in insurance, so my days were spent thinking about risk. After a large loss we analyzed it and many times we asked the question, “Would we write that policy again?” and if the answer was “Yes” then we knew we’d done what we could. When you know you’re going to “lose” probably 65% to 85% of the money you take in, it does alter your perception of risk a bit.
My father was in the Pacific on Destroyers during WWII. He said when he got onboard he worried about Japanese attacks, including kamikazes, but he said after a while he got tired of worrying and being afraid, and just went on with his duties.
Those two things have probably affected my thinking about risk.
Thank you for your thoughts on this and for sharing your story. That’s fascinating about your father’s experience. Isn’t it amazing how quickly the human mind will adapt when placed in extreme environments?
Thanks for a great article Adam. I’m a big believer in managing risk. I’ve written about “margins of safety” which are meant to reduce risk. You hit on the important ones.
Thanks, Rick! I really appreciate it. And congratulations to you on #150!
I always read your posts. They’re well written, actionable, and informative. “Generally right instead of precisely wrong” is the kind of advice that keeps me from going off the rails. Thanks, Max
Thanks so much for the kind words, Max! I don’t know much else about Carveth Read but have always loved that line.
At 7:05 AM, a few hours after publication, Adam’s fine article has essentially received as many ‘likes’ as yesterday’s two AI articles—combined—got in over 24 hours.
Thanks, Nuke. I appreciate that. But I do think it’s wise for us to keep an eye on AI. In my experience, its writing isn’t very interesting, but it’s well-organized, and when it’s accurate, it can be quite helpful in providing basic information. In my view, AI is really just the next generation of search engines. But we’ll see!
But what if we didn’t know they were AI?😀
That’s a hellofa good question Richard.
AI has given new life to that old meme: On the internet, no one knows you’re a dog.
Please DON’T try that experiment.
Gemini: “Please write an 800 word article in the style of HumbleDollar’s Richard Quinn explaining why all retirees should target 100% replacement of their pre-retirement salary regardless of their age, lifestyle or spending habits.” My AI predictor says HD readers should be on the alert….