What is and isn’t “Risk”

It’s a popular thing to bash on measuring the risk of an investment portfolio with standard deviation, the preferred metric of most academic studies. If you skipped stats in college (congratulations, by the way), standard deviation measures how much movement around an average return you might expect in an asset or portfolio.  So higher standard deviation = bigger “swings” in, say, annual stock market returns.

Of course, standard deviation is far from perfect. Most commonly cited is that no one cares about big swings to the upside – a big up year is hardly perceived as risk by any investor!

A popular line from many institutional investors, especially value-oriented stock pickers, is that “the only real risk is the permanent loss of capital.”  Such a nice little soundbite. You hear this all the time, including from giants like Seth Klarman and Howard Marks. And for a stock picker, I suppose avoiding the permanent loss of capital is huge. Especially if you run a concentrated portfolio of 20-30 stocks.

Right now I wouldn’t want to be the guys managing the Sequoia fund, which at the end of the second quarter had a 28.7% stake in Valeant Pharmaceuticals. Valeant is down big ($96.65 today from $178 and change less than a week ago). this week after becoming the target of a short-seller accusing the company of massive fraud. I don’t know or particularly care how Valeant shakes out, but if you have a stock that is over 25% of your portfolio, you don’t want it to go bankrupt. There’s no coming back from that.

The trouble with the “permanent loss of capital” risk definition for most investors is that it is laughably easy to avoid. Anyone who owns one single diversified index fund has done it. Sure, if you have a fund with 3,000 stocks in it, a few are bound to go bankrupt. But those fractional losses are indistinguishable from the day-to-day 1% swings in the broad market. Any diversified investor has effectively eliminated the permanent loss of capital.

So we’re back to other definitions of risk. Despite its imperfections, standard deviation (or volatility, call it what you want) is a pretty decent measurement of risk. No one is shocked to learn that a 90-day T-Bill has less volatility than an emerging market stock. Or that a 30-year Treasury Bond has more volatility than that 90-day T-Bill. And sure, standard deviation measures big swings to the upside right alongside big drawdowns. But the thing is that you can’t find me an asset class that has big upside swings without the big drawdowns.

Here’s everybody’s favorite chart:

2015 callan table

Emerging markets stocks were up 66.42% in 1999! Of course they were down 25% the year before that and down 30% the following year. Small Cap growth stocks crushed it in 2009-2010 up 34.47% and 29.09%, but they were down -38.54% in 2008, worse than the S&P 500. Nothing gives you high double-digit gains without the occasional double-digit loss, unless you’re Bernie Madoff.

The last argument against using volatility as a measurement of risk is usually “So what?” Many value stock managers like to act as if huge one-year drawdowns don’t matter in the long run. They don’t want to talk about risk-adjusted returns. Well, maybe they don’t interact with their investors very much, but volatility matters to investors for two very real reasons.

  1. Drawdowns are hard to deal with, emotionally. Big losses can make for skittish investors. I don’t care how “experienced” you are as an investor. It is still hard. I remember in 2008-2009 talking to very intelligent, longtime investors who were really convinced (for a myriad of reasons we’ll get into some other time) that this time was worth being scared. Each new bear market is scary. It’s different, the economy is different, your life is different, your portfolio’s behavior is different. Each and every time. Successful investors have to stick to their investment strategy throughout these periods. We are often the greatest risk to our own portfolio, and a very real risk indeed.
  2. Drawdowns can be hard to deal with, financially. Warren Buffett is famous for saying that his favorite holding period is “forever,” but you aren’t Warren Buffett. At some point in our lives, most of us will spend money regularly from our investment portfolios. If you’re taking regular distributions, volatility matters a lot. A big drawdown can put a portfolio’s longevity at risk if liquidity is insufficient, withdrawals are too large or the drawdown is too deep. Platitudes about indefinite time horizons are lovely, but real life doesn’t always work that way. Volatility as risk matters to the bottom line of any portfolio funding regular withdrawals.
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