By Scott Reed
Risk is an interesting thing. For instance, there is more risk of injury crossing a busy street than mountain climbing. However, there are very few videos on YouTube of people simply crossing the street, whereas there are movies and videos galore showing people climbing the face of an ice-covered mountain.
That’s because mountain climbing appears to be a dangerous activity. Certainly, one wrong move could have very bad consequences. In street crossing, we expect others to look out for us, so we don’t have to look out for them. I see people crossing the street every day with their heads down, reading their phones and paying no attention to the cars that may be barreling down the street with drivers who are looking at their own phones.
I would take my chances on an ice face with a rope, crampons and ice axe versus crossing the street in front of a driver who is texting, talking, emailing or any of the other things that drivers of huge metal objects do these days.
Understanding risk is important to the success of an investment process. But equally important is the understanding of what risk does to the psyche of the investor. We measure risk in our business by determining how much movement or fluctuation there is in a portfolio – how much something will potentially move up or down. We look at the standard deviation of an investment to determine how much risk it has.
Frank Sortino developed the Sortino Ratio, which isolates the downside risk. He realized most investors don’t get too upset if their investments outperform on the upside. Outperforming on the downside, on the other hand, is a big problem. I like using the Sortino Ratio in much of my due diligence of investments. I think it makes a lot of sense.
For instance, if you have an investment with a projected return of 10 percent and a standard deviation of 12, then your most likely range of returns – better than 95 percent chance – would be -2 percent to 22 percent. Compare that to an investment with a projected return of 5 percent and a standard deviation of 10. Its most likely range of returns would be -5 percent and 15 percent.
Which investment seems more risky to you? Most people would say that the potential loss of 5 percent of your portfolio is more risky than the potential loss of 2 percent. However, the first investment has the greatest standard deviation. That is the problem with using shortcuts when making investment decisions. It makes you feel like you are making good sound decisions when possibly you are not.
It is critically important to get this risk thing right. All the time I hear people in our business say how important it is for their clients to be able to sleep at night.That sounds nice and is very true, but the biggest reason you have to get this risk thing right is because if you don’t, you will make some very bad decisions. Investing brings out the emotions in investors and you have to stay in a portfolio that doesn’t push the wrong buttons that will force you into making bad decisions.
If you wake up one day and realize your portfolio is down more than you can comfortably stand, you don’t start thinking about what a great buying opportunity it may be, you start thinking about getting out. Getting out at the lows is not normally the goal of investors. If your portfolio goes up much more than you planned, it is easy to start looking at loftier goals that would require even more money.
So instead of selling high, you may start thinking about buying more. Buying high is another client goal we don’t expect to see; however, it is exactly what many investors do. One way to protect yourself from the temptations of the markets is to make sure you understand the risk you are taking and make sure that it is appropriate and comfortable for you. That way you can avoid making bad choices and you will sleep even better at night. If you do all that and still have trouble sleeping, it could be sleep apnea and that I can’t help you with.
Scott Reed is CEO of Hardy Reed in Tupelo.