Managing Risk | Part 1: The Insidious Nature of Averages

Author: Nathan Rowader
Date: September 4, 2014
Category: Financial Planning
Tags: , , ,

In my last post, I discussed some important steps to achieving your financial goals, one of which is understanding and managing risk. Unfortunately, this is easier said than done. So, over the next few weeks I am going to dig a little deeper into the topic of risk and also discuss some methods of managing risk that you might be able to use in your own portfolio. First, let’s start by defining risk.

What is risk?
Most people understand the return part of their portfolio. When a $10,000 portfolio increases to $11,000, we understand that we made 10%. But how does risk fit into this portfolio? Risk is really a discussion of how that return was achieved and whether or not that return could be easily achieved again. Let’s look at two hypothetical approaches to achieving that 10%:

2014-09-blog-nrowader-managing-risk-tablePortfolio A achieved the return in a very stable investment such as a bank certificate of deposit (CD), while portfolio B was invested in something much more volatile. Volatility becomes a very important measure for a portfolio because it introduces the effect of timing into a portfolio’s return. The investor in portfolio B would have realized a terrible return had they needed to sell their investment in the fourth month. In this case, had an investor known these would be the outcomes, no one would have selected portfolio B. The unknown future is a source of anxiety for many investors. To alleviate this anxiety, many of us default to planning for our futures by relying on average returns. This, my friends, is a mistake of the highest order.

When you assume…
Dr. Sam L. Savage, a consulting professor of engineering at Stanford University, authored a book called The Flaw of Averages, which addresses the dangers of using averages as part of the decision-making process. The book provides a myriad of examples of how the average of a dataset can actually lead to inaccurate and, in many cases, dangerous assumptions.

To illustrate, let’s imagine that we developed a plan in which we invested $200,000 in an S&P 500 index fund and we withdrew $30,000 each year from the fund. If we assumed an annual return of 12%, which is the approximate historical return of the S&P 500, then this plan would last roughly 15 years. However, as most of us know, the S&P 500 isn’t a smooth line of daily and monthly gain—it fluctuates. That fluctuation is the risk we are taking by investing. When we take money out, timing becomes essential since we may remove money in a less than optimal market, thus reducing the chance of making up the money during a recovery. In fact, given the level of risk and return in the S&P 500, we could only achieve the above plan 11% of the time. Despite the fact that the average return meets our objectives, the actual distribution of positive outcomes shows us that the odds of success are very low.

Most financial plans rely quite heavily on averages and view risk as a static condition or some plans might use a simple method (Monte Carlo simulations are popular) to try and demonstrate a portfolio’s risk. The fact of the matter is that your plan and the risk associated with that plan are living and breathing entities which take the form of other investors. So, it is important to make sure that you or your advisor is active in monitoring and managing the risk in your portfolio. If you are not sure how to do that, I will be following up with some ideas over the next few weeks.

See the rest of the series: Part 2 | Part 3 | Part 4

RISKS

Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

Nathan J. Rowader is a registered representative of ALPS Distributors, Inc.


The information contained on this web site reflects thoughts and opinions of Salient Capital Advisors, LLC (“Salient”) employees only, and the firm is not soliciting any transaction based upon such information.

The contents of this web site are for informational purposes only and may not reflect current financial developments or market conditions. You should not act or refrain from acting on the basis of any content included in this web site without seeking financial or professional advice on the particular facts and circumstances at issue. Salient reserves the right to change any information contained herein without prior notice. Salient is not responsible for any third-party content that may be accessed through this web site. The distribution or photocopying of Salient information contained on or downloaded from this site is strictly prohibited without the express written consent of Salient.

Salient research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Salient recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Salient research or any portion thereof may not be reprinted, sold or redistributed without the written consent of Salient. Salient research is disseminated and available primarily electronically, and, in some cases, in printed form. The information on this web site is for U.S. residents only.

Research and Advisory Services provided by Salient Capital Advisors, LLC, a wholly owned affiliate of Salient Partners, L.P. Salient Capital Advisors, LLC is an investment advisor registered with the U.S. Securities and Exchange Commission.