I recently picked up “Against The Gods – A Remarkable Story of Risk” by Peter L. Bernstein because it was on a number of must-read lists for investing nerds. The book is essentially history book on the topic of risk. It begins with early man and the belief that whatever happens to us in life is due to “the gods”, fate, etc. With the birth of numbers man was able to measure things which eventually led to the measuring of risk. Man also changed his thinking on risk – our actions influence outcome, not fate.
I really enjoyed the final third of the book describing the advancements in risk measurement pertaining to investing over the last 200 years or so. There are a few investing takeaways that I would like to share.
The best description of risk that I know of did not come from this book. It is:
“Risk is what you lose when you are wrong” (original source unknown). This is similar to a Warren Buffett quote which reads: “Only when the tide goes out do you discover who is swimming naked”.
The meaning of these quotes is this: you can “measure” risk all you want. You can use fast computers, algorithms, and formulas. You can “back-test” your strategy until the cows come home. You can say portfolio A should only lose x percent in a 20% market downturn, but you don’t really know the actual loss until the market corrects. Financial history is littered with firms, traders, and financial advisors whose seemingly small risks turned into huge dollar losses. Remember: the “risk” in any trade or portfolio is only a guess, until it is realized. Portfolio A and Portfolio B may both be up 7% this year, but they may have very different risk/reward characteristics. “Only when the tide goes out” will you discover which one was taking too much risk.
In the financial markets we really have two risks, but most people (and financial advisors) only think of one. We have downside risk (everyone loves to talk about downside risk), but we also have upside risk (or the opportunity cost of not being invested). Most people forget about upside risk because the downside looks so scary. As humans we are risk averse – it has been proven that a “loss” negatively affects us much more than an identical “gain”. If you move your retirement portfolio to all cash today, you have taken away your downside risk but now you have all upside risk. If you are retiring in two years and you have enough money to live the lifestyle you want, then an all cash portfolio may be right for you. But most people have a longer time frame and need their money to compound in order to reach their goals. Just because this has been a long bull market does not mean it cannot go on for much much longer. Upside risk is a very real risk for most investors.
Charles Brown is a Portfolio Manager and Financial Advisor at M. Brown and Associates in Naperville, Illinois
*The above article is informational in nature only and is not a recommendation to buy or sell securities. All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information. All investments carry a degree of risk. Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.
**Securities and Investment Advisory services offered through Ausdal Financial Partners, Inc, 5187 Utica Ridge Road, Davenport, IA 52807 (563)326-2064. Member: FINRA/SIPC. M.Brown and Associates and Ausdal Financial Partners are independently owned and operated