Size matters

The excitement that a gambler feelsI wrote earlier about assessing investment plans using probability-based approaches like Monte Carlo simulation rather than naively projecting simple averages. However, a shortcoming of typical probability-based analysis is that it only addresses part of the risk equation.

Probability of shortfall describes the likelihood that an investor could fall short of his spending goals, based on assumptions about his portfolio. This is not, however, a complete picture of shortfall. It considers only the frequency of an outcome, ignoring the consequences.

Think of it this way: it treats falling short by $1 of spending the same as falling short by $1 million dollars, despite the obvious differences between the two outcomes. It’s like the difference between a fender-bender auto accident and a fatality. Both are crashes, but they are very different kinds.

A robust risk assessment considers both probability and magnitude of unfortunate outcomes. Size matters.

Total risk equals probability times magnitude

I think the investment pain many well-diversified investors have felt the past few years is related to this issue. Particularly for those relying on their portfolios for retirement income. While they may have been prepared for the possibility of markets declining, it was the magnitude of the decline and the impact it had on their spending feasibility that surprised them.

This suggests two things to me. First, many investors were likely in portfolios with too much equity for their situation. They liked the return potential and were willing to accept the probability of poor markets, but they were not emotionally prepared for the magnitude of those poor markets.

Second, asset allocation methods which recognize and respond to more sophisticated measures of investment risk have the potential to improve outcomes for investors. This is an area Russell is increasingly focusing research. Diversification never promises protection from losses, but that doesn’t mean it can’t be improved.

Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.

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