Why You Can’t Really Measure Investment Risk

Can you really measure investment risk?

Risk is supposed to be a measure of the likelihood that an event less than expected will occur. For example, if you are flipping a coin and want the coin to land on heads, then the odds of that happening is 50%. The odds of flipping tails is also 50%. The risk involved, assuming that you want the coin to land on heads, is that it will land on tails instead. But, how do you measure the level of risk of your coin landing on heads. The answer may surprise you.

Dr. Yaron Brook, in his lecture “Investing: An Objective Approach“, tells us that there is no real way to measure risk – whether we are talking about coin flipping or investing in the stock market. In order to measure risk, we would need to focus only on the downside, because we are trying to measure more than just the probability of loss. We are trying to determine a “level” or “degree” of risk. However, risk is always measured by figuring in the downside as well as the upside.

Traditionally, the advice given to us by financial advisers tells us that you can measure risk by observing the “standard deviation from the mean”. A simple example of standard deviation can be found at Wikipedia’s entry for “standard deviation”:

As a simple example, consider average temperatures for cities. While the average for all cities may be 60°F, it’s helpful to understand that the range for cities near the coast is smaller than for cities inland, which clarifies that, while the average is similar, the chance for variation is greater inland than near the coast. So, an average of 60 occurs for one city with highs of 80°F and lows of 40°F, and also occurs for another city with highs of 65 and lows of 55. The standard deviation allows us to recognize that the average for city with the wider variation, and thus a higher standard deviation will not offer as reliable a prediction of temperature as the city with the smaller variation and lower standard deviation.

The problem with defining risk this way is two-fold:

1) When we measure risk as “standard deviation from the mean”, we will always get skewed results, because we are trying to measure both the upside (gains) as well as the downside (losses). To accurately measure risk, we would need to discount any positive result and focus completely on the negative. The problem is that there is not really a way isolate the upside from the downside.

2) The current risk model assumes an equal distribution. It assumes the “normal distribution” (i.e. equal distribution) of all financial instruments – which is not reality. Stocks are an excellent example of this. In the 1980s, you would likely not have guessed that Microsoft would have done as well as it did vs. every other company at that time in that industry. It didn’t do just a little bit better but much better. So Microsoft represents an “anomaly” according to the traditional theory – but it actually completely and totally contradicts traditional “theory.”

The current theory of risk really just discounts that people of more intelligence and better ability will do better in the marketplace. That “normal” distribution is just a nice way of saying “mediocre.” That everyone is mediocre or that everyone is the same, and that this is the standard by which everyone should be measured to assess the risk one ought to take with one’s money while investing.

…but not everyone is the same. Some companies have better management, better products, a better marketing department. Three companies in the same industry may have a different view on how to run the company, and this can (and usually does) affect the stock price of that company. One cannot determine the “normal” distribution if “normal” doesn’t really exists – and it doesn’t. Differences are what exist between people, between companies.

Asset allocation questionnaires are subjective

If you’ve ever met with a financial adviser or insurance agent, he or she likely asked you many different questions about your personal financial situation. But when it came time to give you advice about your investments, they more than likely asked you to fill out a questionnaire or they asked you a series of questions about investing.

Unfortunately, financial advisers that we meet with today are taught that the “right way” to determine how risk averse we are to investing in the financial markets is to ask us a series of hypothetical questions about particular investment situations. The key word here is hypothetical. Collectively, they call this an asset allocation questionnaire.  All asset allocation questionnaires contain at least some subjective questioning techniques to elicit answers based on feelings rather than on objective facts that would lead to intelligent investment decisions.

These questions usually deal with “what if” scenarios which may or may not be totally irrelevant to your specific financial situation. For example, a typical question might be:

If you had $100,000 invested in the stock market and your portfolio lost 60% of it’s value, how would you react?

This question is then followed by a series of multiple choice answers. Each answer is then assigned a point value, and at the end of 20 or 30 questions, these points are tallied up and you are awarded a “risk score” and thus your “risk tolerance” is established. This “risk score” determines how your money should be invested (and the financial adviser is compelled by various Government agencies as well as his firm to give you advice based only on your “risk tolerance”)

But, if you don’t have a portfolio of $100,000, then this particular question becomes irrelevant to you. It is very easy to say what you might do in a given situation, and something else to actually do it.

By asking irrelevant questions that may or may not apply to our specific situation, a financial adviser actually encourages subjective financial advice. Notice that these questions ask us to react based on feeling – they try to stir up emotions in us (either positive or negative) and then ask how we would react based on how we feel. This methodology can lead us into poor investment choices that we either choose ourselves or that our adviser recommends to us.

An adviser may never explicitly tell you that this is what he or she is actually doing, only an inference is made: “well Mr. X, ‘ABC fund’ returned 12% this year and it has done that for the last 3 years, and your risk tolerance suggests that this would be a suitable investment for you.”, “I think the fund manager is doing a good job.” or “…they seem to know what they are doing over there.”

Often times, no objective measure of how the fund is doing (or ought to do in the future) is made. Since your risk profile has been created, very little time needs to be spent on researching and analyzing the fund, and the fund’s manager. The risk profile creates an artificial sense of security that “this is where you are supposed to be” – removing thought, discipline, and control over your investment strategy.

Despite the ranting and utter stupidity espoused by the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD, now called the FINRA), risk can only be assessed by the individual – you personally. And your “risk tolerance” will have to be determined by perhaps a very pronounced effort on your part. Your investment strategy – any investment strategy – requires an immense amount of thought, discipline, and control.

Instead of letting your emotions lead the way, try to be objective. Make decisions based on reason, and see how you feel about your answers after the fact. Are you more concerned about making gains in the stock market, or preserving the money you have? Why? Do you want to invest everything you have in the stock market, some, or just a little? Why? Learn as much as you can about investing before putting any of your money in the stock market.

Some general guidelines that may help:

None of the above should be construed as investment advice or a substitute for investment or financial advice, but rather just some things to think about. At the end of the day, if your investment decisions leave you feeling uneasy or anxious, then it may be a sign that you have made the wrong decision. In the end, only you can determine how much risk you want to take on based on your values and financial goals. If you don’t know how to define those objectively, a good financial adviser can help you.

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February 12th, 2013 | by David | No Comments