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


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