The successful management of money is not a glorious task. It is not the superb selection of specific issues that tends to produce long-term results. Instead it is an unwavering commitment and discipline to managing risk. Long-term investment performance, in large part, is achieved by the effective management of risk.
Investment risk comes primarily in three forms. There is the risk that the markets you invest in do not perform well on an overall basis; this is systematic or market risk. There is the risk that the individual investments you select do not perform as well as the markets they represent; this is unsystematic or idiosyncratic risk.
And there is the risk that the investor takes actions that are harmful to their long-term returns; this is behavioral risk. All three forms of risk can be managed.
The Context of Risk
Time is a great determinant of risk. As time horizons increase, the potential effects of both systematic and unsystematic risk on a diversified portfolio decrease.
The range of potential returns narrows across time; a long-term portfolio has a lower overall risk profile than does a short-term portfolio. This makes sense as factors that have a significant short-term impact will have less impact across longer periods of time.
Despite time being an ally in addressing long-term risk, risk is inherent in any investment. Risk is inseparable from real rates of return.
A real rate of return is that portion of an investment’s or portfolio’s return that is in excess of the rate of inflation. It is only to the extent that we exceed the rate of inflation that our spending power grows — and that is our real return, our increase in spending power.
You cannot have a long-term increase in spending power through investments without having meaningful risk. As you cannot avoid it, it behooves you to know how to manage it.
Systematic and Unsystematic Risks
You can deal with systematic and unsystematic risks mostly through normal investment risk-management techniques.
Diversification is having multiple investments to mitigate risks associated with a particular security or a particular market or market segment. It is often referred to as “not having all your eggs in the same basket.” It would be better to define it as “not having just eggs.”
Having multiple similar investments provides a degree of protection against unsystematic risk. For example, if your portfolio consists of holdings in the stocks of 10 large companies and nothing else, you have slightly reduced your unsystematic risk. But you are not well diversified, and you have not properly addressed this risk.
Proper diversification requires having diversification within asset classes, as in the example above. It also requires having diversification among asset classes — “not having just eggs.”
Diversification among asset classes, particularly when done via an asset allocation methodology, can reduce unsystematic risk considerably and systematic risk to a lesser degree.
The problem with systematic risk is that it can broadly affect a number of asset classes or theoretically even all asset classes.
Diversification across asset classes reduces the risk associated with individual asset classes but cannot eliminate the risk of a broad decline across all markets. Systematic risk is manageable, but it can’t be eliminated.
Much has been written about the importance, and the mechanics, of diversification and asset allocation and using these tools to manage risk. Many investors and investment advisors could speak at length about the ins and outs of techniques and strategies and how to implement them in an individual’s portfolio structure.
You might think, then, that our portfolios should soar like eagles, yet many people may feel their portfolios more waddle like ducks. The third form of risk is often the culprit.
Behavioral risk includes many factors that cause investors to unknowingly sabotage their returns.
If an investor follows an asset allocation strategy that utilizes a formal methodology for portfolio rebalancing, they may mitigate a portion of their behavioral risk. But even for an investor doing a good and competent job of managing systematic and unsystematic risk, behavioral risk may be the major cause of lower than desired portfolio performance.
A major form of human behavioral risk is our aversion to loss. We do not treat an equivalent loss or gain equally; we consider a loss to be far bigger deal than a gain of the same magnitude. We don’t even process them in the same place in the brain. The pain of loss far exceeds the pleasure of similar gain.
Since we are hardwired for loss aversion, we tend to make decisions to avoid loss more so than to create gain.
Couple this with some FOMO and we may want to bail out of investments that are down a little bit and want to hang onto those at the top of their cycle — exactly the opposite of how we make long-term gains in the market.
We know we should buy low and sell high, yet investors want to sell those assets that are relatively down and hang onto or even purchase more of those assets that are relatively up.
This is one aspect of behavioral risk that is mitigated through the use of an asset allocation strategy that has a formalized mechanism for rebalancing. Using a formalized mechanism for rebalancing forces us to use rules instead of emotion as the driver of our investment decisions; the rules have us sell what is relatively high and purchase what is relatively low.
The primacy effect is a cognitive bias where we tend to better remember the first and early pieces of information more so than those that come in the middle or later. A form of this is the anchoring bias, in which we tend to latch onto the first piece of information, whether or not it is important or relevant to our particular situation.
We might, for example, hear a piece of news talking about a hot new product that is coming to market. The news people want to catch our attention, and often do so with bold claims as to an innovation’s potential. They embellish on the potential a bit, with tidbits of information presented in descending order of hoopla.
Lastly they may discuss some risks or potential roadblocks the innovation faces, letting us know that it is not a done deal or a sure thing.
Our biases have us focusing on and recalling best what came first — the big hoopla. In particular, we anchor on that first sensational piece of information that seems almost too good to be true. For an investor, this can appear to be a hot tip, yet it can be a very expensive hot tip if the investor fails to exercise due diligence and do their homework.
The Solution to Behavioral Risk
We could talk about human biases and their negative impact on investment performance at length. But we don’t need to in order to work around them. We don’t need to understand all of our internal workings and design flaws.
All these things served us well at some point, they kept our early ancestors from being eaten by tigers or whatever else was stalking them back in the day. But they don’t help us in the realm of long-term investing.
We need to utilize process and procedures that remove whims and excess emotions from our investment decisions.
We need criteria that we use to select our investments and we need criteria for what we should be adding to or removing from our portfolios. It is not glamorous or sexy but it works repeatedly. And that is the essence of investing.
Investing is a replicable process in which we can have a reasonable expectation of a level of positive return across a period of time. There is no room for hot tips or for getting in our own way by trying to outthink a proven process.
If we have good rules and procedures and follow those rules and procedures to manage risk, we can vastly reduce systematic risk and unsystematic risk and the biggest risk we face, that which we have wired into ourselves.
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