Everyone may define risk in different ways. However, when it comes to investing money and planning for the future we believe risk management is paramount. So, if there are many views of what risk is how can we properly manage it?
The first step toward a logical and sensible investment plan is to match goals with expectations. Fundamentally, we believe this comes down to risk management during the portfolio construction process. Risk, from our point of view, can be defined by two broad terms. First is the risk of permanent loss (i.e. buying high and selling low). This is putting in $100 and taking out something less than $100 in the future. Second is the risk of coming up short (i.e. making poor investment decisions). This could be from a combination of different factors, but it is easily defined as requiring $200 twenty years from and ending up with a sum less than that amount. While there are many other risks to be considered they all stem from the two listed above. Yet one risk as purported by academics and theoretical models is volatility and to us volatility does not matter.
Volatility is not significant – logically – if you meet all your goals. Besides, how can anyone estimate volatility beforehand? We personally find it hard to believe that a mathematical model, based on past events, can magically predict the future. After all, by definition, the future is unknowable. In the end we are playing the probabilities across a broad range of potential events. The goal is to put the probability of being successful in your favor.
The proper active management strategy puts the odds in the investors favor. Active management intentionally selects investments based on their fundamentals. When performed well over a long period of time active management can protect on the downside. However, it can also limit the upside as an active manager with a focus on valuation will become less invested as prices rise faster than the underlying economics. Therefore, in a time of a rapidly rising market the type of active manager we hire will typically underperform. We always caution that the correct measurement period for any investment should be over a full cycle (i.e. trough to trough or peak to peak). For example, see the chart below for the potential benefit a good active manager can provide over several market cycles.
There are many options when constructing a portfolio. However, a portfolio should be constructed in the way that best helps an investor achieve their goals.Active management when performed adequately may provide a margin of safety and help put the odds in your favor. What a lot of people will want to know is what risk the investor had to endure to get the “Good” outcome. We don’t believe this is a useful question for two reasons. First, we can only know the risk –as measured by standard deviation – after the fact. Second, it really does not matter if your goal was to have $200 on 08/31/2014; you achieved what you wanted.