The Investment Risk that Matters Most

Investment risk is the most important concept in investing, yet investment returns are typically the sole focus in many investment discussions.

It's easy to understand why: Investment returns are quantifiable and investors can quickly check the performance of companies and their own portfolios with a tap on the smartphone.

On the other hand, risk is cerebral, abstract and difficult to measure. Nevertheless, we know that investment risk is real even though each investor defines and experiences it differently.

There are several proxies for measuring risk, but for individual investors investing to fund their future goals, there’s only one risk that truly matters: The Risk of Underfunding Your Goals.

But before diving into that, let’s first define what constitutes good risk and bad risk.

Good Risk and Bad Investment Risk

A fundamental principle in investing is that investment risk is rewarded with higher expected returns. Investors are compensated for adding uncertainty into their investment portfolio; otherwise, why would a rational investor voluntarily accept more risk?

However, not all risk compensates investors with a higher expected return. Non-systematic risk, for example, introduces additional uncertainty without improving expected returns. This type of risk is often linked to overly concentrated, non-diversified portfolios.

Because diversification is both simple and inexpensive to implement, the market does not reward investors for taking on this risk that is unique to a specific company, asset class or geography.

So, while "good" risk is necessary to generate investment returns above inflation, not all risk is compensated. But how do we actually measure the risk of an individual investment or portfolio?

Ups, Downs and Standard Deviation

As the fields of finance and investment management have matured, both academics and practitioners have agreed on defining risk as the degree of dispersion around an expected outcome (or average). Historical risk, or volatility, of an asset is easily quantified with statistical measurements, with standard deviation being the most common. Simply put, the more an asset price fluctuates, the riskier it is perceived to be.

While a simple measurement enables empirical research and helps practitioners understand potential outcomes of investments over a set time period, does volatility matter to long-term investors? Wouldn't the law of averages dominate investment returns over time?

Although standard deviation is not the best measure of risk for individual investors seeking to fund future goals, volatility still matters for at least two reasons:

1. Psychologically, it is difficult for some investors to watch the value of their life savings fluctuate significantly. Beyond stress, this can lead to sub-optimal decisions, such as selling investments in depressed markets.

2. Quantitatively, high volatility can lead to lower investment returns regardless of the average return. For example, a 50% drawdown requires a 100% return just to break even. This imbalance is known as volatility drag.

   
   

But for individual investors that are investing in order to fund future goals, the most important risk to manage is straightforward...

The Risk that Matters Most For investors saving to meet future goals—like retirement, education, or a vacation home—there’s really only one type of risk that matters: the risk of underfunding those goals. A better way to view risk is not in terms of dispersion around an average or expected return, but rather the dispersion of potential outcomes in relation to funding a specific goal.

Let’s consider a simple example: An investor has a goal to fully fund their child’s university education in 10 years, which will cost $100,000 in today’s dollars. The investor currently has $80,000 to allocate toward this goal, meaning the goal is 80% funded.

The investor could invest the $80,000 in a safe asset that tracks inflation. While this would preserve the $80,000 in today’s terms, the goal would remain underfunded by 20%, no more and no less. The problem to solve is determining how much risk the investor needs to take on to reach the $100,000 goal.

One option is to allocate $50,000 to the safe asset (covering 50% of the goal) and invest the remaining $30,000 in a risky asset that has the potential for a higher return. To meet the $100,000 goal in 10 years, the risky asset would need to generate at least an annual 5.25% real return. The investor would track the funding status and adjust the allocation each year based on actual returns and updated capital market expectations.

Wrap-Up Ultimately, the risk that matters most is not volatility or short-term market fluctuations, but the risk of failing to fund your specific financial goals. By aligning investment and planning decisions explicitly with financial goals, it provides a simple framework to construct, track and adjust an investment portfolio that minimizes the risk of underfunding future goals.

​If you have questions on this concept of Goals-Based Investing, feel free to grab time on our calendar.

Thanks for reading,

Mark Chisenhall, CFA, MBA

Financial Advisor | Founder of Taurus Financial Planning

Taurus Financial Planning is a Fee-Only Wealth Management firm based in Bentonville, AR. The firm offers comprehensive financial planning, tax planning and investment management to corporate executives across the country.

Taurus Financial Planning is a Registered Investment Advisor with the State of Arkansas. This information is provided as a guide to assist you in your financial planning. The specific examples are provided for illustration purposes only and are not representative of specific investments or guarantees of future returns. Please consult with a professional for specific questions regarding your particular situation. If there is any error or inconsistency between this document and the official company plan documents, your company plan documents will govern.

This publication is for informational purposes only and is not intended as tax, accounting or legal advice or as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.