Risk and Volatility

 Risk:

• expose (someone or something valued) to danger, harm, or loss.
•  a situation involving exposure to danger.

 The term "risk" is regularly thrown around investing conversations.  I find it interesting that it is used to insight both fear and to encourage greed.  The same concept, or perceived concept, is referenced to fortify the position or posture of people with completely opposite intentions.

"We are in a risky period for the markets"
"You should take more risk as a young investor"
"How much risk is in your portfolio"
"That manager takes quite a bit of risk"
"Now is not the time to reduce the risk in your portfolio"
"Risk on - Risk off"

These and many more like them are often heard or read in the financial world on a daily basis.  It begs the question, what is this risk being referenced? Is it what most laymen think it is?  Is it an accurate word for the purpose of the speaker/writer's point?  Is the common understanding of the word risk being properly applied and responded to?

Typical individual investor comments or conversation attach the topic of risk to a negative result.  Nearly all reference to "risk" is concerning a loss of some sort, from total capital loss to negative performance, discussions center around just one side of risk - the downside.

In the investing world, risk is associated with loss but is most often measured by volatility.  They are not the same thing.  Most any cursory review of economics will explain that there is a relationship between "risk and return".  Ostensibly, more risk means more return.

The more accurate way to approach this axiom is more volatility, more potential return.  Standard Deviation is a mathematical measurement of  price change or deviation from a norm.  In finance, the greater variance allowed, the greater chance of higher returns. Yet, the actual risk of achieving that return grows exponentially, not in a linear fashion, as the spectrum of possibility increases.

The primary question to be wrestling with, to discuss with your Advisor or consider in your planning, is to determine what is most appropriate for your investment and/or emotional stability.  How much volatility do you need versus how much volatility can you handle.  A well built and purposed portfolio can engineer this with quite a bit of consistency.  If designed well, "risk" can be significantly reduced but volatility can remain.  As an engineer of portfolio construction, M2 accepts volatility as an indicator of benefit.  But that doesn't mean we don't have triggers, tactics, etc. that have certain tolerances that prevent or initiate change when extreme markets occur.  Capitalism, competition and needed investment growth requires variation and volatility.  We embrace the concept.  Risk of total loss on a macro basis, cam be addressed so as not be a concern.  There is much history and available tools to nearly eliminate this concern of complete loss.  In fact, the various Insurance carriers and large Wall St. firms would be happy to have you pay them to take this total loss risk.  We don't believe that is necessary or prudent.

The Sears Tower in Chicago is an iconic, tall building stretching 1450 feet into the skyline .  Few people realize, that on average the tower regularly sways 6 inches.  It is engineered to allow up to 3 feet of movement at the top, in order to spread the forces across the entire building.  Were it designed to never move at all, failure would be likely since all the pressure force would be centralized at the base.  The choice an architect makes is either make the tower significantly shorter or engineer an amount of flex to provide for stability and thus a tall building.

Investing is not that much different.  Well built portfolios accept, even predict, volatility.  Without it, returns must be expected to be "shorter".

Our next post will address the question:  How does stewardship, prudence and responsibility work within the context of "taking risk"?