February 15, 2011
How should clients think about risk in their portfolios? Advisor Perspectives put that question to a cross-section of prominent advisors and academics. Their answers encompassed diverse opinions and underscored how crucial that question is to the investment process.
In part one of this series, we hear from seven practitioners in the financial planning community. Next week, we’ll hear from a group of well-known academics, including a couple of Nobel Prize winners.
We asked each person the following questions:
- How should a 25-year-old, who is beginning to save for retirement, think about and measure the risk in his or her portfolio?
- How should a 65-year-old, who is beginning the withdrawal phase of their retirement, and the adequacy of whose portfolio is precarious, think about risk in his or her portfolio?
We were not asking how that person should invest, but rather how they should think about risk.
Here are the responses from Carl Richards, Bill Bengen, Roger Gibson, Rob Arnott, Harold Evensky, William Bernstein and Jonathan Guyton.
Carl Richards is the founder of Prasada Capital Management, based in Utah. He is author of the Behavior Gap, a column on personal finance.
Volatility and risk are not the same thing, though they are often treated as such.
Risk is what is left over after we think we have thought of everything. It is the "unknown unknowns." Viewed in that light, which is not the conventional industry perspective, the entire discussion of measurement and management of risk takes on a different tone.
The traditional view of risk traces back to economist Frank Knight, who in 1916 began (and largely ended) this discussion for our industry. Knight, a founder of the “Chicago school of economics,” made a distinction between risk and uncertainty and set the course for the industry to focus on risk as he defined it – what we think of as volatility. Knight’s approach was, and still is, convenient in the sense that risk, as defined by Knight, can be measured and managed. The issue is that most real people don't view risk this way. To most people, risk is indeed what is left over after you think you have thought of everything, or what Knight referred to as uncertainty. Uncertainty is messy, impossible to manage, and therefore often left out of the discussion.
When, in the sterile lab of modern finance, we say that risk equals volatility, we assume that the range of outcomes is pretty much fixed within a normal distribution (bell curve). Our clients, however, face uncertainty, and the greatest risks to their portfolios are the things that are left over after we think we have thought of everything. It is often said that the last four words of any great investor are "this time it's different," but do we really believe that the limited historical data we have represents a complete set of outcomes? Is there any room for the possibility of unknown unknowns?
When we talk about risk management, whether to 25-year-olds or to 65-year-olds, clients think about risk generally, not as an abstract academic idea. This difference in the way we communicate risk leads clients to expect things that we simply can't deliver.
We need to review the role that uncertainty plays in portfolio management and how we communicate this reality to clients. Open conversations about the nature of risk and the uncertainty we face when making portfolio decisions can go a long way toward setting realistic expectations and helping clients understand that even after all we can do, the future is still uncertain. Our job is not to forecast exactly what will happen but to be there to help them deal with events as they come.
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