It is well over sixty years since Professor Harry Markowitz introduced Modern Portfolio Theory to investors- creating a paradigm for investing that is still widely used today. Despite its flaws, the theory successfully introduced the idea of measuring the risk of an investment, and suggested that a portfolio of investments could be combined to provide a maximum level of return for a specified level of risk. Investors, thus, could create an optimal portfolio based on the level of risk they were willing to accept. This is now seen as orthodox investment management advice, but was truly revolutionary thinking in 1952. Subsequent research and improvements in mathematical modeling and computer technology have made quick work of creating a well-diversified portfolio of investments that should help reduce risk and improve overall return. But is it really so simple? Decades of experience and hindsight have shown that accurately measuring investment risk, and an investor’s reaction to it, is a thorny issue. It is also an area where good advisors can help tilt the odds of capturing long-term portfolio growth in the favor of investors.
The definition of the word risk is “the potential of losing something of value.” Investors that are unwilling to tolerate the uncertainty of losing money are said to be conservative investors, while those that can accept this uncertainty are thought to be more aggressive. While this is a reasonable starting point, it ignores the impact that human capital plays in the perception of risk, and it fails to differentiate between the capacity to accept risk and the willingness to accept it. More importantly, it focuses on the perceived pain of short-term fluctuations in account values at the expense of a permanent loss of capital. While stocks may be more volatile than bonds, they are likely to be much less risky when the ravages of inflation are considered. To really measure risk, we need to expand upon the traditional measurements.
Human Capital refers to our ability to exchange our services in return for something of value, generally money. Not surprisingly, the young have higher levels of human capital than the elderly, and may allocate savings for purposes of building wealth. They may also recover more easily from temporary losses in their investment portfolio because they are not yet reliant on it to provide income. In contrast, the elderly have utilized much of their human capital and do rely on their accumulated assets to meet their retirement income needs. Short term market volatility may be much more impactful to them. As people move along the continuum from worker to retiree, their tolerance for risk is thought to diminish, and traditional measures of risk tolerance generally make this assumption.
Risk Capacity, expands upon traditional risk tolerance by recognizing that financial capital, not human capital, drives retirement income. It factors in stable sources of income that retirees have, which may allow them to invest far more aggressively than traditional risk tolerance would suggest. Whether they need to, or wish to, invest in this manner is another matter. Combing the tolerance for risk, required portfolio returns and risk capacity will provide a more nuanced view of how best to construct a retirement portfolio.
A final distinction should be made between risks that investors can recover from and those that result in permanent losses in capital. The former, while painful, are the focus of most risk tolerance discussions. The permanent loss of capital from inflation impacts investors young and old, and should be considered when making asset allocation decisions.
While many younger people often have a higher capacity for risk, they too may lack the tolerance to accept volatile markets. The result can be the allocation of investments earmarked for long-term goals in safe investments that offer little opportunity for growth. When this occurs, investors are required to save more money to fund their retirement and often fall far short of their goals.
In contrast, older people that rely heavily on their investment portfolios for income, and have a low capacity for risk, may nonetheless have a high tolerance for it, and attempt to make up these shortfalls by investing very aggressively. Both scenarios are suboptimal.
Risk is an important, but elusive, concept when making portfolio allocation decisions. It is critical that investors recognize not only their tolerance for market volatility, but also their capacity to accept risk. Matching the retirement income portfolio’s investments to stated income goals is a good start. Recognizing the risks that result in real losses in capital versus those that are painful but temporary setbacks are an often overlooked and critical element to long-term success. A risk questionnaire will rarely provide this sort of insight, but a good advisor will.
John Male, CFP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
The Retirement Maven ™
9 East 40th Street, Suite 1500
New York, NY 10016
Tel: 212-221-7067 Ext. 17