Investing is all about balancing risk and return to achieve your long-term goals. I think everyone understands returns (especially when they're negative), but what about risk? In finance, the most popular approach incorporates the volatility or standard deviation of an investment's returns. Standard deviation may sound a bit mathy, but if you break down the term – standard or average and deviation or dispersion – it is just a measure of the variability of returns. Of course, many more metrics have become common, including downside deviation, up/down market capture, and drawdown. Really, they are all trying to paint a picture of the risk of an investment based on its variability of returns. But is that 'risk'?
Take risk-adjusted returns such as the popular Sharpe ratio (return divided by volatility). Both investments A & B in the chart below have the same return over the time period; however, A takes a much more volatile path to reach the same destination. Does that make B better than A? B certainly has a higher Sharpe ratio, but both result in the same wealth creation. This is where
risk really depends on you, the investor.
If you agree that risk is not just a function of volatility but of the investor, below we explore investor characteristics that also determine risk.
Behavioural Fortitude – Investing is an emotional endeavour, probably because we all care pretty deeply about our wealth. And greater volatility increases the risk of making a behavioural mistake when investing. On those big upswings, the Fear-of-missing-out (FOMO) may encourage adding more or taking on more risk. Conversely, during those downswings, the pain of losses (unrealized) can become realized losses if an investor capitulates.
If you are more likely to make a behavioural mistake due to market volatility (up or down), investments that are more volatile increase the risk of you making this kind of mistake. This applies to all investors, young or old, wealthy or less wealthy. If you have a greater fortitude to remain the course during periods of volatility, this is less of a risk.
Accumulation phase – For those with a long time horizon and are currently in the accumulation phase, meaning net savings and regular contributions to your portfolio, volatility is less meaningful as a measure of risk. Simply put, the longer the accumulation phase remains for an investor, market volatility is less impactful, and the long-term return rate is much more important. It is the destination that is important, not so much the journey. Instead, the focus should be more on wealth creation, saving more and generating a healthy return.
Critical 10 - The term critical 10 is often used to describe the final five years of accumulation and the first five years of decumulation. Different risks begin to arise during this phase and will last into the decumulation phase.
Decumulation phase – Ah, the golden years. Unfortunately, the golden years also come with more types of risk.
The above graphic is for illustrative purposes only as everyone's journey is different, and of course, there are many additional factors. The goal is to highlight that risks do change over time, and it goes beyond simple 'market risk' or volatility.
The Buffer – in many cases, these different risks are not addressed directly but instead are grouped into a financial plan's 'buffer' or safety buffer. If spending rises more than expected or life goes on longer, it simply eats into the buffer, resulting in a smaller residual (estate). Bigger is obviously better when it comes to a 'buffer,' yet understanding the changing risks is helpful. And if the buffer is smaller, understanding the risks become more important.
For the most part, portfolio construction is focused on creating thoughtful, well-constructed portfolios with an emphasis on risk (volatility) and return. Just look at the increased popularity of alternatives as a way to provide improved diversification (less volatility). This approach is ideally suited for the accumulation phase, as risk and return are the dominant considerations. Save more, grow your assets and avoid shooting yourself in the foot (behavioural mistakes). But is it time to start rethinking how we construct portfolios in the decumulation phase?
It is no longer just risk and return; there are many additional considerations. Individuals with a pension, annuity, or pension-like investments (such as Purpose's Longevity Pension Fund) that help address longevity risk can focus other investments more on other risks. Such as real assets or equities that can keep up with cost inflation better. Or focus more on return in the hopes of leaving a larger estate or protecting from a potential spike in spending needs later in life.
Portfolios likely need more customization as the combinations and permutations of income sources, risks, and goals vary greatly during the decumulation phase. And they continue to change over time. It is no longer just about standard deviation.
— Craig Basinger is Chief Market Strategist at Purpose Investments
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