March 21, 2016
Saying that “Risks are everywhere!” isn’t necessarily a profound statement, but it’s important to recognize from a high level that there are risks present in every aspect of our lives. In most cases, we generally handle the risk by either avoiding it, knowingly accepting the risk, reducing the frequency or severity of the risk, or transferring the risk to either another party or an insurance company.
A probability/frequency vs severity matrix is a great way to illustrate the different types of risks inherent in our lives and how we should handle the risk:
Each of the four quadrants represents a unique category of risks that should be handled differently based on the probability of occurring and the potential negative impact it may have when it occurs.
This probability vs impact framework is useful to understand when referencing perceptions of risks in many aspects of life. This matrix is often used when discussing the need for insurance, but it can also be applied to the framework of investing. One of particular interest to me is the risk inherent in investments, measured in a variety of different ways, commonly referenced as standard deviation or maximum drawdown. Since the S&P 500 fluctuates regularly and has historically always recovered after major drawdowns, the risk of drawdown for the S&P 500 fits well within the upper left quadrant (High Probability, Low Impact), especially if investing during someone’s early years of life. Stocks generally will significantly rise and fall dozens of times during each investor’s wealth accumulation phase of life, and most investors can take on the majority of this risk early in their life with a long time horizon ahead to smooth out the bumpy ride to retirement. With that said, as the time horizon decreases and an investor approaches retirement, the number of large swings the person is expected to experience will be reduced, as a function of less years to invest, which shifts the risk down toward the bottom box; at the same time, the sequence risk during the first few years of retirement when the retiree first begins withdrawing funds shifts the risk to the right, because beginning to withdraw money from an investment after it falls has devastating effects on the money’s ability to compound over the coming years.
This tendency for an investor’s portfolio to begin in the top right quadrant in an investor’s early years and to shift toward the lower left quadrant by the retirement years is the reason why investors tend to progressively increase their bond allocations over the course of their lives to reduce risk. Theoretically, bonds provide a stable portion that might even rise in value when stocks fluctuate downward, and by adding this stable/uncorrelated portion to the portfolio, it could potentially have both fewer and less severe drawdowns than holding a portfolio made up of entirely stocks. With that said, I don’t necessarily think the traditional approach of combining stocks and bonds is the best way to managing investment portfolio risk to match a person’s risk tolerance; however, it’s a good framework to start the discussion. As I plan to illustrate in future blog posts, understanding risk in the context of building investment portfolios is essential to making well informed decisions of how to best achieve your individual financial goals.