Balancing risk, return and investor behavior
Investors typically invest in order to address specific economic problems. Generally, they are trying to invest savings accumulated over time to create “enough” wealth at some specific point in the future. As a general rule, most investors want as much certainty as possible that they will have the requisite amount of wealth on the day they need to start spending it. That said, most investors can’t afford as much certainty as they would like.
For example, if investors are willing to save 25% of their income every year of their working life until the age of 65, then it’s likely that they can “afford” to invest in only conservative investments like bonds and cash. In other words, because their savings rate is so high they can “afford” to get the lower return offered by these conservative investments.
But, the likelihood that individuals or even corporations can afford to defer 25% of their income every year is very, very low. Many would prefer the volatility (certainty) of the return pattern offered by bonds and cash, but the tyranny of the math is such that they can’t afford to invest only in those assets.
Herein lies the basic challenge: given that most investors require a higher rate of return than their preferred risk level is likely to provide, most need to take on more risk than they would ideally desire.
Facing the realities of risk
Traditionally, the investment management industry has concentrated on annual volatility (standard deviation of annualized returns) as the primary measurement of risk. But we think the most important risk investors should consider is actually the risk of not achieving the outcome they seek, or not having enough wealth upon retirement to fund an attractive lifestyle without constant worry.
This conundrum is why we at Russell believe an effective investment approach aims to provide the required rate of return at a level of risk the investor can survive. By “survive” we mean that investors can stay invested and stick to their long-term investment plan designed to get them toward their desired outcomes.
Framing the issue this way can be a helpful way to talk to clients about how much risk they want to take and how much risk they might need to take to make success in achieving their desired outcome probable.
Humans typically prefer less volatile return patterns, so a more stable return pattern may be more “survivable.” In my view, that’s what makes diversification such a powerful investment strategy, even though it can’t guarantee a profit or protect against loss.