When I meet with new investment customers, I routinely ask them to describe their comfort level with risk. My second question is often “do you know how much investment risk you are currently exposed to?” In 16 years of managing other people’s money, I have never met an investor that could answer this question with any level of accuracy.
Investment risk is defined as the difference between actual returns and expected returns. Expected returns often match the investment’s historical performance and as most investors are being reminded in real time, “past performance is not a guarantee of future performance.”
So how does an investor learn about the risks of a particular investment? Certainly, the publicly traded investments are sold by prospectus and within the prospectus will be a discussion of the risks associated with the stock, ETF, mutual fund, etc. Investors can often find basic risk statistics such as standard deviation, beta and sharpe ratio on the investment companies website or on websites such as Morningstar.com or CNBC.com.
Without proper interpretation, these statistics can be misleading in the same way that historical returns can be. And while the numbers are surely accurate, it’s important to understand that the commonly available risk statistics are only the starting point. For example, it is important to understand whether an investment’s historical volatility is left-tail (investment returns less than zero) or right tail volatility (investment returns above zero). Since it is left-tail risk that investors are mostly concerned with, it is important to examine the skewness of the distribution of returns. An investment that historically has seen 85 percent of monthly returns in positive territory might be more comfortable than an investment where half the monthly returns are negative.
One of my favorite risk measurements is one developed by Zephyr Style Advisor called “Pain Index.” The Pain Index measures the severity of losses, the frequency of losses and the duration or length of time that the investment was below zero.
The pain index provides the investor with a sense of what the investor experience was like for a given period of time. Obviously, investors would prefer smaller, infrequent losses over shorter periods of time.
In my practice, there are 125 risk statistics that are available for the mutual funds and separately managed account managers that we work with. If you haven’t had an in-depth conversation about investment risk, perhaps now might be a good time to review your investments with an investment advisor that can help you understand your current level of risk.
If you would like to meet with us to review your investment portfolio and current level of risk, please feel free to email me at [email protected].
Securities offered through LPL Financial, Member FINRA/SIPC
No strategy assures success or protects against loss.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
-Written by Michael Hamrick
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