What Does Risk Mean to You?

Depending on who is describing it, risk may suggest: not achieving your goals, not retaining purchasing power, running out of money, not being able to maintain a desired lifestyle or not providing a legacy for future generations.

From an investment portfolio perspective, volatility is often adopted as a common measure for quantifying risk. Volatility measures the swings associated with fluctuations in asset prices or portfolio values. Despite being widely used in the investment industry, there are several highly successful investors that reject the use of volatility to describe risk.

Legendary investment giant, Charlie Munger, who passed away at 99 years old in November last year, was not a fan of volatility as a measure of risk. Munger’s definition of risk was “the possibility of harm or injury” and argued that the probability of permanent loss of capital was a more appropriate description.. Another investment icon, Howard Marks writes: “Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in calculations and models of modern finance theory.”

One of the most insightful pieces, which considers long term investment risk, that I have read in recent years is entitled “Risking, Fast and Slow” by Nick Maggiulli. The publication offers an unconventional approach towards risk by ignoring traditional risk measures such as standard deviation/volatility. The author suggests that there are two kinds of risk – slow risk and fast risk.

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Slow risk is not immediate and takes time to accumulate. Smoking cigarettes is an example from everyday life - there is no immediate harm from this activity, however, the consequences accumulate and can be severe over a longer period.

Fast risk is immediate -- such as the potential consequences from not reacting to “a rustle in the grass” when walking through the jungle. As humans, we have evolved to avoid fast risk.

Putting this into the context of an investment portfolio, cash may be considered slow risk and equities/stocks may be considered fast risk. The nominal value of cash will remain unchanged, but its real value will slowly be eroded by inflation over the course of decades, while stocks could decline by 20% or more in a matter of weeks (it’s happened countless times in history).

The chart below shows the probability of an investment (cash or stocks, in this case) being down greater than 5%, after inflation over various holding periods, from 1926 through to 2021. The probability of cash being down 5% or more in real terms over a 1-year period is 6% and the probability of stocks (as measured by the S&P 500 Index) being down 5% or greater, after inflation, over a 1-year period is 22%.

However, if we take a longer-term perspective, the outcome changes. Over a 20-year period, the probability of cash being down greater than 5%, after inflation, is 31% and the probability of stocks being down greater than 5%, after inflation is 0% over the same period. As an investor’s time horizon increases, the risk of losing money in stocks (fast risk) decreases and the risk of losing money in cash (slow risk) increases, after inflation.

Note: All returns adjusted for inflation. Cash Return is 1 month Treasury Bills and stock are S&P 500 Index returns. Vertical axis is measured as Percentage of Months.  

The above example is extreme and only considers cash and stocks. As asset class allocators who invest across the risk and return spectrum, determining the appropriate combination of slow risk and fast risk is complex and unique to each individual. If an investor can withstand greater short-term temporary swings in portfolio value, then it may be reasonable for them to consider trading some slow risk for fast risk in their portfolio, albeit, without compromising the probability of achieving their goals. Some people may argue that slow risk is unimportant in this context, as long as objectives are met.

As defined by Investopedia “risk capacity” refers to the amount of risk an individual/family or organization can responsibly take on without jeopardizing their financial stability or other key objectives. For those investors with sufficient risk capacity, the concept of slow risk illustrates the penalty of being too conservative or overly pessimistic in their approach toward long-term investing. The reason this is important is not because they may have generated greater returns versus their friends or their peers or the market generally. It is important as this may ultimately lead to falling short of their financial goals. As goals-based advisors, for us at Northwood Family Office, not meeting a family’s goals is slow risk.

“A goal without a plan is just a wish” - Antoine de Saint-Exupéry

“The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome.” - Peter L. Bernstein

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