“Many of the things you can count, don’t count. Many of the things you can’t count, really count”
Risk: a four-letter word that many people avoid discussing in polite company. Yet living in a world of uncertainty forces us to face the cruel fact that we have no idea what tomorrow brings. In reality, this is the very essence of risk. Professor Elroy Dimson has said: “Risk means more things can happen than will happen.”1 One of the actions we can take to prepare for the future, is to set a little aside today to help us through tomorrow; forgoing gratification today, in the hope of gratification tomorrow. Contrast this with investing, which we define as forgoing gratification today, in the hope of more gratification tomorrow. It is in this attempt to expand our purchasing power that financial risk is encountered.
Our ancestors were keenly aware of how to deal with risk. In fact, our bodies are specialized machines that once instinctually sprang into action when staring down a saber-tooth tiger. Rapid breathing and heartbeat, flushing skin, dilation of pupils, tunnel vision, shaking, and sweating,2 are all symptomatic of our limbic system’s natural reaction known today as fight or flight. So how do we not turn this system on every time the stock market moves 100 points in the wrong direction? The keys to remaining calm under pressure are being prepared and knowing where you stand. We are dedicated to following this strategy to help you reach your goal of lifetime financial success.
Our fascination with financial risk has its genesis in games of chance played with astragalus, or knuckle bones, in ancient Egypt and Greece before 3,500 B.C. Legend has it that Modern Finance owes its existence to Blaise Pascal and Pierre de Fermat in the 1650s. Trying to mathematically deduce the proper method of splitting the stakes in an unfinished game of balla, Pascal and de Fermat invented, in rudimentary fashion, the mathematical disciplines of Probability and Statistics. These disciplines were later harnessed to create methods for calculating expected returns and expected deviations in returns by Harry Markowitz in his 1952 thesis, Portfolio Selection.3
Today’s Modern Portfolio theory attempts to provide the maximum return available at a given level of risk- a noble cause. Defined as volatility, risk is measured as the squared deviations from the mean or expected return; these deviations are based on past results. At this point, correlations (the tendency of assets to move either together, or in different directions) are added to the formula to predict future expected portfolio returns and risk in an elegant mathematical process. Our argument with Modern Portfolio theory is not mathematical in nature, the math behind it is correct. Our differences spring from the assumptions used to make the math relevant:
- Maximizing average annual return is not our goal, helping you achieve a lifetime of financial success is our goal. One year is not sufficient time to measure progress, let alone success.
- Minimizing volatility in the form of annual deviations from the mean is not our goal, and not how we define risk. We accept volatility as a normal part of investing.
- Past volatility and past correlations are not guaranteed, or possibly even expected to predict, future volatility and correlations.
So where does this leave us? As previously mentioned, John Maynard Keynes once quipped: “I’d rather be vaguely right, than precisely wrong”. It is in this spirit that we try to be humble in our use of mathematics and think about all things in both their quantity, as well as in their quality. It is in the measurement of investment risk that this discipline is most important. Why utilize complex mathematics when common sense will do? The answer can be found in our lead quote from Einstein about counting only the things that count.
Our process for managing risk can be explained in three dimensions: Understanding, Recognizing and Facing5:
- Understanding: Based on the work of William Bernstein6, we classify risk in two dimensions: Shallow Risk and Deep Risk. Shallow risk is volatility, or normal fluctuations in the prices of assets that cause account balances to move up and down even though the income and earning power of the portfolio remain the same. Deep Risk is permanent loss of capital- a loss in earning power that stems from either an equity investment being permanently impaired, or a fixed income investment not earning sufficient return to outpace inflation, both events reduce purchasing power. In other words, shallow risk may cause you to lose sleep, but deep risk may cause you to go hungry. We accept volatility as a normal part of investing, one that we are rewarded for over long periods of time. We dedicate our time to avoiding deep risk.
- Recognizing: From the heights of ivory towers risk is measured in terms of deviations from the mean, but down here on the ground, we define risk as the possibility that we “may lose a real chunk of money that you used to own7”. It is not so much the fluctuations, deviations, or correlations that we concern ourselves with- it is committing your capital to an operation that will likely reduce your purchasing power over your anticipated holding period that we try to avoid. The most important factors in recognizing risk are avoiding speculative operations and managing the price you pay. Which is why these axioms headline our Principles.
- Facing: “The relation between different kinds of investments and the risk of loss is entirely too indefinite and too variable with changing conditions to permit of sound mathematical formulation.”4 We aspire to control our emotions, our liquidity, the number of decisions we make, the time-period over which we measure our progress, and most importantly the price we pay. While the fluctuations of security prices can be both exciting and devastating, they are completely outside of our influence. The price we pay, however, is firmly in our control. When it comes to facing risk, it is important that we have faith and knowledge that the process we used to select our securities is sound, and that we have the strength and fortitude to make decisions without emotion, and based on probable future outcomes, not past costs or decisions.
In summary, when managing risk, we have two options: Risk Mitigation and Risk Avoidance. Risk Mitigation is developing a system that attempts to reduce either the frequency or the impact of a risk event. Risk Avoidance is attempting to eliminate a risk. Our processes are designed to mitigate the impact of Shallow Risk and avoid the risk of Permanent Loss of Capital. We mitigate Shallow Risk by diversifying your portfolio, maintaining adequate cash, and using a long-term time horizon. We attempt to avoid Deep Risk by investing with a margin of safety and not speculating.
Our main directive is to help you define and reach your goals, both financial and otherwise. While pulling in to the destination is fun, it is the journey that really matters. The hardest part of this financial journey is not extrapolating the past into the future, and preparing for risks that are yet unknown. Our Principles are designed for just this task, and have worked for decades through widely varying markets, economic climates, and political environments. If long-term evidence ever indicates our principles are wrong, we will adjust them after careful analysis and deliberation.
Spring is slowly approaching. As the harshness of winter recedes, volatility in both the markets and weather are picking up. While I can hardly speak to fluctuations in the weather, the fluctuation in the market is almost certainly a function of rising interest rates, though the madness of crowds is difficult to quantify. We will continue to apply our Principles in an attempt to help you sleep well and eat well. Thank you for your continued trust. Our entire team is here to help you define and reach your goals, especially when volatility picks up.
1 Dimson, E. (n.d.). London Business School, London, England. Last Letter.
2 Fight-or-flight response. (2018, March 03). Retrieved March 23, 2018, from https://en.wikipedia.org/wiki/Fight-or-flight_response
3 Bernstein PL. Against the Gods: the Remarkable Story of Risk. New York: John Wiley & Sons; 1998.
4 Graham, B., & Dodd, D. (1934). Security Analysis. New York: McGraw-Hill.
5 Marks H, Davis CC, Greenwald BC. The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor. New York: Columbia Business School Pub.; 2013.
6 Bernstein WJ. Deep Risk: How History Informs Portfolio Design. United States: Efficient Frontier; 2013.
7 Schwed F. Where Are the Customers Yachts?, or, A Good Hard Look at Wall Street. Hoboken, NJ: John Wiley; 2006.
The title takes its name from the confused tourist who upon being shown the "Brokers' Yachts" ask naively, "Where are the customers' yachts?".