In the world of personal finance, people debate about everything. Among these arguments is the question of how to measure risk. In general, partisans on this topic fall into one of two camps.
In the first group are those who believe risk can be quantified and distilled down to a single number. For these folks, the most common numerical yardstick is portfolio volatility—that is, the degree to which a portfolio’s price tends to bounce around from year to year. Portfolios exhibiting lower volatility are deemed safer.
On the other side of this argument are those who believe it’s misleading to summarize risk with a single number. That’s because volatility can mean different things in different situations. When a stock declines rapidly, that’s called downside volatility, and no investor welcomes that. But there’s also upside volatility—when a stock has risen rapidly. Take a highflying stock like Apple or Amazon. Because their prices have risen much faster than the overall market, they too have exhibited above-average volatility. Because of that, and according to the textbook, they’re viewed as very risky. But they’ve also been very profitable. It’s for this reason that many view volatility on its own as a less-than-perfect tool for investors.
Another problem with quantitative measures of risk is that they ignore the human element. Consider, for example, a portfolio with average volatility of 15%. Is that good? It’s hard to say because no portfolio exists in a vacuum. Rather, portfolios belong to people (or to institutions), and everyone is different.
It’s for these reasons that I’m wary of quantitative measures. Risk, in my view, is multifaceted and, to a great degree, personal. That said, if risk can’t be measured quantitatively, then how can it be measured? This is admittedly difficult. That’s why I suggest that we not worry so much about measuring risk and instead put more focus on managing it. To that end, below is a brief risk management playbook.
Early years: If you don’t yet have significant savings, risk management might not seem like a concern. But it is. During these early years, it just takes a different form.
As we move through life, we have, in a sense, two account balances. First is the traditional type of balance—what we have in financial assets. The second type of balance is what’s known as human capital. This refers to our future earning potential. Over time, as we log more years in the workforce, our human capital will decline. But at the same time, our financial capital should increase.
That’s why, if you’re early in your career, the most important thing is to do everything you can to protect your human capital. What does this mean in practice? The key is to secure disability insurance and, if you have a spouse or children, life insurance. While not inexpensive, these two types of coverage can help protect your human capital during the early years.
Working years: Over time, insurance will still be important. But as you build your savings, you’ll want to take steps to protect your financial assets as well. How? The key lever here is asset allocation. Because the stock market can be erratic, investors need to maintain enough outside of stocks—in cash or bonds—to carry them through future market downturns.
If you’re a net saver, though, you might question whether this is even necessary. Indeed, it’s a question many people ask: If I’m adding to my savings and not withdrawing, why not invest every dollar in stocks to maximize growth? That certainly has intuitive appeal, but there are two reasons you might choose to be a bit more conservative.
You may have heard the term “black swan.” Popularized by a book of the same name, a black swan is an event that’s completely unexpected. The origin of the term is helpful in appreciating its meaning. In many parts of the world, including Europe, all swans are white, so historically it was always assumed that swans everywhere were white. But in the 1600s, when Dutch explorers landed in Australia and found that black swans were prevalent, they learned a lesson, and one that’s applicable to personal finance: We should be careful not to dismiss possibilities—or risks—just because we’ve never seen them before. The risk of a black swan, then, is the first reason you might choose to be more conservative with your portfolio during your working years, even when you have no specific need to draw on your savings.
What does this mean in practice? For younger families, I don’t normally recommend a traditional portfolio with specific percentages in stocks and in bonds. Rather, I recommend deciding on a specific amount of cash and simply holding that at all times to guard against a potential black swan.
There’s another reason you might consider holding a cash buffer like this. The psychologist Daniel Kahneman, who recently passed away, developed an idea he called prospect theory. In short, Kahneman and his colleague were the first to recognize that people dislike losses disproportionately more than they enjoy gains. Since bonds can moderate losses when the stock market falls, this is a second reason you might want to hold some savings outside stocks even when it doesn’t seem necessary.
To be sure, asset allocation should never be our only focus. Other priorities include managing taxes, keeping costs low and avoiding complexity. But I see these as secondary. During the arc of your working years, the stock market will likely go through multiple cycles. If your portfolio is structured such that these ups and downs impact you less, that, I believe, is the most important thing.
Retirement: As you approach retirement, risk management takes a different form. At this stage, you’ll likely no longer need life and disability coverage. Instead, managing portfolio risk will be paramount. This is a topic I’ve addressed before, but in short, to arrive at an appropriate portfolio structure, I suggest asking these three questions:
- How much risk do I need to take?
- How much risk can I afford to take?
- How much risk can I tolerate?
There’s a fly in the ointment, though: If you work through those questions, I suspect you’ll find there isn’t just one answer. For most people, there is a range of asset allocations that can make sense. How can you settle on an answer? Psychologist Gerd Gigerenzer has spent his career studying risk and decision-making and suggests an approach he calls “fast and frugal.” His advice: Avoid trying to over-engineer an answer. Because the stock market is inherently unpredictable, greater and greater levels of analysis may only make us more confident in conclusions that are still ultimately just guesses. As a result, counterintuitively, trying too hard to reduce risk can actually result in greater risk. Gigerenzer cites the collapse of the hedge fund firm Long-Term Capital Management as an example of this phenomenon.
The bottom line: As long as you’ve given a good amount of thought to the questions outlined above and choose an asset allocation that is in the appropriate range, you shouldn’t worry any further. As the English philosopher Carveth Read once wrote, “it is better to be roughly right than precisely wrong.”
