By Stephen Horan, PhD, CFA, CIPM
In the most fundamental sense, wealth management is concerned with two things: risk and return.
It’s very easy to focus on return, but the reality is that you need to focus on both. That’s why I’ve spent the last few weeks talking about ways to manage risk with insurance or insurance-linked products, such as annuities.
For the average investor, the biggest financial challenge is to invest savings to create a portfolio with a sustainable withdrawal plan during retirement. In creating this sustainable portfolio, the investor faces three paramount risks: longevity risk, inflation risk, and investment risk.
I have touched on longevity and inflation risk in previous columns, but before we move on to investment risk, I’d like to reiterate one point: Preparing for retirement is becoming more difficult.
Now that life expectancies are on the rise, investors must be prepared to be retired for 30 to 40 years. These lengthy time frames represent substantial longevity risk and leaves open the possibility for inflation to impact a portfolio in dramatic ways. (Please see my thoughts on hedging your personal longevity risk in my second post about annuities.)
If all a wealth manager does is keep longevity and inflation risk in check for a client, the manager is covering important bases. That’s not all there is to wealth management, but these two things are vitally important and are sometimes overshadowed by a focus on investment risk.
That said, even if an investor has longevity and inflation risk under control, an investor still faces investments that can be volatile, even over longer periods of time. Moreover, investment risk certainly influences the other two. So, let’s spend some time on it.
Managing Investment Risk
Most people say that volatile investments like stocks are less risky for investors who have a long investment horizon. The idea is that the ups offset the downs, if you stay invested over the long term. In fact, if stock returns are relatively random over time (which has more or less been the case historically), then the range of possible outcomes (risk) in your ending portfolio value actually increases over time. It doesn’t decrease in the long run.
You may have seen analyses that demonstrate that the probability of losing money or underperforming a certain benchmark decreases in the long run. However, the magnitude of the loss, should it occur, grows greater and greater. That is why it is so important to control investment risk.
As you may have gathered, I’m a numbers guys and I rely heavily on probabilities in my analyses. I manage investment risk for the same reason I buy life insurance. It’s unlikely that I will die any time soon and need my insurance coverage, but the economic consequences of not being covered could be very large. Although it’s not necessarily likely that I will lose money investing in the capital markets over the long term, the risk remains, and it is a big risk because of its potential consequences.
Apparently, I’m not alone in my thinking about downside risk: In a recent CFA Institute paper called “The Long-Run Risk of Stock Market Investing: Is Equity Investing Hazardous to Your Client’s Wealth?” Zvi Bodie, a professor at Boston University, said that relying on the conventional wisdom that stocks are not risky in the long run can be dangerous to the terminal wealth goals of individual investors.
That’s why, in closing, I’d like to encourage you to look for innovative ways to manage your investment risk and suggest you focus on “terminal” wealth as the indicator of investment progress, as opposed to a percentage return (or loss) reaped over the course of your life. “Terminal” wealth is the dollar amount in your portfolio that’s available to be spent at the time you retire. This figure can help you decide when to retire or what size home you can maintain during retirement, something a percentage point can’t do.
In my next article, I’ll talk about whether alternative investments and structured products are useful tools in managing investment risk.
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