Quiz!
Which is a riskier situation?
- 1M invested in a stable investment that grows by 5% per year and never declines.
- 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.
A Hidden Measure of Investment Risk, Beyond Volatility
This article debunks a conventional wisdom that equates volatility with risk, and ignores all other factors. The following example demonstrates a problem with this narrow focus. Compare the following two situations:
- 1M invested in a stable investment that grows by 5% per year and never declines.
- 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.
By focusing on volatility alone, you would conclude that the first investment is less risky. This conclusion is wrong. The lowest balance that the stable investment can reach is 1M, since it never declines. The lowest balance that the volatile investment can reach is 1.2M, since it starts with 3M and can go down by up to 60% of the peak. The first investment is riskier for two reasons: (1) it grows more slowly on average, and (2) it has a lower worst-case balance. Your risk of running out of money with this investment is greater.
Since the starting investment amounts are different in the two cases, how can this apply to the real world? An example could help:
- Say you have 1M invested in a stable investment.
- The investments grow to 1.1M through a combination of investment growth and new savings. This allows you to shift your investments towards higher expected growth along with higher volatility. Specifically, the investments can potentially decline by another 100k (10%) during declines, to get you to the prior risk during declines.
- You repeat the step above, leading to higher and higher expected growth, while keeping the risk level the same.
- Your investments reach 2.5M, and you reached an allocation for maximum potential growth, along with potential declines of up to 60%. Your risk level is still the same with the lowest balance being: 2.5M x (1 – 60%) = 1M.
- Your investments reach 3M, and you keep the allocation the same, since you already enjoy the maximum potential growth. But now the lowest your investments can reach is up to 3M x (1 – 60%) = 1.2M, giving you higher security, despite the much higher volatility.
Notes:
- Risk is determined by spending/investments, not investments alone. To account for expenses going up or down, you should track spending/investments, not just the investment balance.
- Another risk factor is the valuations (P/B = Price/Book, or price relative to intrinsic value or liquidation value). In diversified portfolios, high valuations lead to higher risk (greater potential decline), and lower valuations lead to lower risk (lower potential decline).
- Some stable investments are exposed to inflation risk, making them riskier than seems. On the other hand, there is no guaranteed maximum decline for any investment. It is all a matter of odds.
- If higher volatility leads you to panic and sell low, that is another risk factor that can take away the financial benefits described above.
- While income from work can be lost at any point, some jobs are much more secure than typical (e.g. doctors), and can help your risk profile.
Implications:
- A plan that may be risky for someone else, may be conservative for you (and vice-versa), depending on your respective ratios of expenses/investments & valuations.
- A plan that would have been risky for you a few years ago, may be conservative for you today (and the reverse is potentially true if your expenses grow faster than your investments).
Quiz Answer:
Which is a riskier situation?
- 1M invested in a stable investment that grows by 5% per year and never declines. [Correct Answer]
- 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.
Explanation: See article for explanations.
Disclosures Including Backtested Performance Data