Risk Is Not What You Think

[Shane H Norman1]

Among professional investment managers, risk is defined, primarily, as a return that is either higher or lower than expected. A better-than-expected return is a risk? Absolutely. It usually means the investment is riskier than anticipated.

Ch-ch-ch-ch-changes
That’s because the higher the return, the greater the risk in terms of how often and how much asset prices move up or down, both in relation to the market (relative risk) or to a so-called risk-free investment such as cash or cash-equivalents (absolute risk). This is also called volatility.

View attachment 154

It measures the extent to which asset prices swing above and below their longer-term trend. It matters a lot to, for example, fund managers because a surge in the number of fund investors wanting to redeem might coincide, as often happens, with a major market setback, leaving the fund short of the necessary cash.

There are many investment types and instruments, each with its particular level of risk or volatility. A common illustration of this is the ‘risk pyramid’, with the riskiest investments at the top and the safest forming a wide base.

View attachment 156

Often, private investors focus only on the two lowest levels, thereby condemning themselves to low returns. At present, these don’t even compensate for the inflation that is continuously eating at the supposedly safe capital of the over-cautious.

On the other hand, no prudent investor should commit all of their money to the pyramid’s top levels.

The safety dance
The time-honoured methods for managing investment risk are, first, diversification, and, second, risk-weighting. The first entails investing across different assets (cash, bonds, equities, and real estate, for example), and/ or different markets (the USA, Japan, Germany, the UK, etc), and/ or different sectors (technology, retail, finance, and so on).

The purpose is to ensure that, even when some assets may experience price weakness, others may not and, overall, your investment portfolio will be less volatile and, therefore, safer. In short, diversification means not carrying all of your eggs in one basket.

Risk-weighting requires holding less of the riskier investments, with the majority of your holdings devoted to cash, bonds, and top-quality equities (‘blue chips’). For example, you might allocate 90 percent of your portfolio to blue chips, government bonds, and cash, but only 10 percent to property and crypto-assets.

Living in the past
However, the world of risk is much broader than simply the volatility of asset prices. Besides, volatility is measured by looking at its past trend and assuming that will continue. When you think about it, that seems misguided. Risk is all about the unknown future, so how can its known history be a reliable indicator?

The past 20-25 years has thrown up many examples of such broader risks, some almost completely unexpected. There have been the usual - and more predictable - market events, notably, the ‘dot-com’ bust of 2000, but major risk surprises came with the Brexit referendum and US election results of 2016. More recently, in 2020, we had the once-in-a-century worldwide coronavirus pandemic. Overarching all of these has been the existential risk of climate change.

It all seems as if the infamous Murphy’s Law prevails: what can go wrong, will go wrong. That being so, what’s the point of taking any risk at all? Those risk-averse investors who put all of their money in bank deposits and government bonds can, surely, sleep better and have fewer worries than those of us holding equities and watching the prices gyrate every day?

Crash and burn
The answer lies in the earlier point that the higher the return is, the greater the risk. In other words, you have to embrace risk - within reason - in order to achieve a reasonable rate of return. This is best achieved with an investment portfolio that is both diversified and risk-weighted, as described above.

That prudent low-volatility (or low-risk) strategy can reduce short-term losses in a market downturn, while its long-term performance could, at least, match that from the market and is likely to outpace cash returns by a wide margin.

The graph, below, compares what happened to a notional pair of lower-risk and higher-risk investment portfolios in the 2000-03 dot-com crash and the Great Financial Crisis (GFC, 2007-09). On both occasions, the high-volatility portfolio suffered sharp falls while its low-volatility counterpart saw much smaller setbacks.

View attachment 155

Not only that, but the low-volatility portfolio delivered much better long-term returns. Its lead may have been only 0.9% a year but, had it been worth £1,000 in June 1973, it would have been valued 45 years later, in June 2018, at £139,601. That compares with just £96,971 for the high-risk strategy, a difference of no less than 44%.

This result seems to overturn the risk-reward trade-off, where taking less risk also means accepting a lower return. How can that happen?

Pledging my time
Time is the answer. The more of it that you have, the better chance your investments will perform well. Market crashes are temporary. They tend to happen every 10-12 years but are usually over in three years or less.

Over the 45 years measured in the chart, there were three such setbacks, being the two already mentioned plus another in 1972-74. That was a total of about nine years of falling share prices, far less than the balance of some 36 years during which share prices were mostly rising.

Given time, therefore, a lower-risk strategy not only reduces the damage from market downturns, but rewards you with a head start when prices resume their long-term climb.

The comparison reveals another truth about risk. Many undertake investment in shares and other assets mainly in order to make money. That approach puts the cart before the horse, because a prudent investment strategy must be based, first, on a thorough assessment of the risks. Only when those have been measured can you make a reasonable assessment of the likely return.

Or, as someone tweeted not so long ago: “It’s not about making a killing; it’s about not getting killed”.

 

[magellan1]

Thanks for sharing your interpretation of risk in investing. Risk management is one of the most important skills in portfolio management. The history of investing is full of famous investors and institutions who had fanatic track records but ultimately failed due to poor risk management (Long Term Capital Management, Barings Bank, etc).
I agree with your main message but I have a different opinion on some points.
Firstly, diversification helps mitigate the risk of poor performance of a portfolio due to a single asset (stock, bond, etc) but it also usually leads to mediocre performance. One needs to have a few bets that turn out to be correct to achieve stellar performance. Berkshire Hataway has invested 3/4 of its capital in just 5 holdings. At the same time, Warren Buffet is the one who is often quoted as saying "Do not put all eggs in one basket". There is a lot of room for interpretation of this statement. What does one basket mean? 1, 2, 3 or 4 stocks?
Secondly, volatility is just one way to define risk. It is very popular because it is easy to calculate/understand and not because it is very robust. There are several alternative/unofficial ways to measure risk such as the probability of default of a company, generating high nominal but low/negative real returns and failing to meet one's target investment objectives. Credit Suisse is a great example of the unreliability of traditional risk indicators. The stock had a Beta (standard risk measure) of around 1.3 which is just slightly higher than the whole market but the value of the shares went to 0 very fast.

 

[Shane H Norman1]

Thanks for sharing your interpretation of risk in investing. Risk management is one of the most important skills in portfolio management. The history of investing is full of famous investors and institutions who had fanatic track records but ultimately failed due to poor risk management (Long Term Capital Management, Barings Bank, etc).
I agree with your main message but I have a different opinion on some points.
Firstly, diversification helps mitigate the risk of poor performance of a portfolio due to a single asset (stock, bond, etc) but it also usually leads to mediocre performance. One needs to have a few bets that turn out to be correct to achieve stellar performance. Berkshire Hataway has invested 3/4 of its capital in just 5 holdings. At the same time, Warren Buffet is the one who is often quoted as saying "Do not put all eggs in one basket". There is a lot of room for interpretation of this statement. What does one basket mean? 1, 2, 3 or 4 stocks?
Secondly, volatility is just one way to define risk. It is very popular because it is easy to calculate/understand and not because it is very robust. There are several alternative/unofficial ways to measure risk such as the probability of default of a company, generating high nominal but low/negative real returns and failing to meet one's target investment objectives. Credit Suisse is a great example of the unreliability of traditional risk indicators. The stock had a Beta (standard risk measure) of around 1.3 which is just slightly higher than the whole market but the value of the shares went to 0 very fast.

 

[Shane H Norman1]

Thanks for sharing your interpretation of risk in investing. Risk management is one of the most important skills in portfolio management. The history of investing is full of famous investors and institutions who had fanatic track records but ultimately failed due to poor risk management (Long Term Capital Management, Barings Bank, etc).
I agree with your main message but I have a different opinion on some points.
Firstly, diversification helps mitigate the risk of poor performance of a portfolio due to a single asset (stock, bond, etc) but it also usually leads to mediocre performance. One needs to have a few bets that turn out to be correct to achieve stellar performance. Berkshire Hataway has invested 3/4 of its capital in just 5 holdings. At the same time, Warren Buffet is the one who is often quoted as saying "Do not put all eggs in one basket". There is a lot of room for interpretation of this statement. What does one basket mean? 1, 2, 3 or 4 stocks?
Secondly, volatility is just one way to define risk. It is very popular because it is easy to calculate/understand and not because it is very robust. There are several alternative/unofficial ways to measure risk such as the probability of default of a company, generating high nominal but low/negative real returns and failing to meet one's target investment objectives. Credit Suisse is a great example of the unreliability of traditional risk indicators. The stock had a Beta (standard risk measure) of around 1.3 which is just slightly higher than the whole market but the value of the shares went to 0 very fast.

 

[JustAnotherHuman1]

Thanks for sharing your interpretation of risk in investing. Risk management is one of the most important skills in portfolio management. The history of investing is full of famous investors and institutions who had fanatic track records but ultimately failed due to poor risk management (Long Term Capital Management, Barings Bank, etc).
I agree with your main message but I have a different opinion on some points.
Firstly, diversification helps mitigate the risk of poor performance of a portfolio due to a single asset (stock, bond, etc) but it also usually leads to mediocre performance. One needs to have a few bets that turn out to be correct to achieve stellar performance. Berkshire Hataway has invested 3/4 of its capital in just 5 holdings. At the same time, Warren Buffet is the one who is often quoted as saying "Do not put all eggs in one basket". There is a lot of room for interpretation of this statement. What does one basket mean? 1, 2, 3 or 4 stocks?
Secondly, volatility is just one way to define risk. It is very popular because it is easy to calculate/understand and not because it is very robust. There are several alternative/unofficial ways to measure risk such as the probability of default of a company, generating high nominal but low/negative real returns and failing to meet one's target investment objectives. Credit Suisse is a great example of the unreliability of traditional risk indicators. The stock had a Beta (standard risk measure) of around 1.3 which is just slightly higher than the whole market but the value of the shares went to 0 very fast.

Is a fact that one can only achieve higher returns with higher risk, but there is also this:

https://en.m.wikipedia.org/wiki/Efficient_frontier

which is basically to say that one can achieve the same rate of return with a lower variance, if diversifying away risk that can be diversified away (investing in uncorrelated assets).

 

[Shane H Norman1]

I don't agree with your argument that diversification leads to mediocre performance. Certainly, returns will be lower than those for the upper percentiles in a peer group; that's the cost of lower risk. But mediocre? The sample low-volatility portfolio I cited suggests otherwise, but I also call on Fama and French and their studies on the efficient frontier in diversification [EDIT: It seems another great mind was having the same thought as I composed this - thank you, JustAnotherHuman!].

On the other hand, as a lifelong contrarian and value investor, I'm deeply sympathetic to your point about Buffett and the concentrated Berkshire Hathaway portfolio. However, that approach requires really deep knowledge of each investment to counteract its higher risks. Few of us have the resources to acquire that. Even among professional investors, the strategy usually founders on the difficulty of persuading clients to buy into it (I've been there and have the scars). Buffett is, perhaps, the exception that proves the rule.

We're on the same page regarding volatility as a measure of risk. As I noted, risk is about the unknown future, so its known history can't be a reliable measure. Given another 1,000 words, I'd have expanded on that to emphasise that risk is not a number and, in another riff on Buffettism, I might have said that it's better to be approximately right than precisely wrong!

 

[TheReformedInvestor1]

Among professional investment managers, risk is defined, primarily, as a return that is either higher or lower than expected. A better-than-expected return is a risk? Absolutely. It usually means the investment is riskier than anticipated.

Ch-ch-ch-ch-changes
That’s because the higher the return, the greater the risk in terms of how often and how much asset prices move up or down, both in relation to the market (relative risk) or to a so-called risk-free investment such as cash or cash-equivalents (absolute risk). This is also called volatility.

View attachment 154

It measures the extent to which asset prices swing above and below their longer-term trend. It matters a lot to, for example, fund managers because a surge in the number of fund investors wanting to redeem might coincide, as often happens, with a major market setback, leaving the fund short of the necessary cash.

There are many investment types and instruments, each with its particular level of risk or volatility. A common illustration of this is the ‘risk pyramid’, with the riskiest investments at the top and the safest forming a wide base.

View attachment 156

Often, private investors focus only on the two lowest levels, thereby condemning themselves to low returns. At present, these don’t even compensate for the inflation that is continuously eating at the supposedly safe capital of the over-cautious.

On the other hand, no prudent investor should commit all of their money to the pyramid’s top levels.

The safety dance
The time-honoured methods for managing investment risk are, first, diversification, and, second, risk-weighting. The first entails investing across different assets (cash, bonds, equities, and real estate, for example), and/ or different markets (the USA, Japan, Germany, the UK, etc), and/ or different sectors (technology, retail, finance, and so on).

The purpose is to ensure that, even when some assets may experience price weakness, others may not and, overall, your investment portfolio will be less volatile and, therefore, safer. In short, diversification means not carrying all of your eggs in one basket.

Risk-weighting requires holding less of the riskier investments, with the majority of your holdings devoted to cash, bonds, and top-quality equities (‘blue chips’). For example, you might allocate 90 percent of your portfolio to blue chips, government bonds, and cash, but only 10 percent to property and crypto-assets.

Living in the past
However, the world of risk is much broader than simply the volatility of asset prices. Besides, volatility is measured by looking at its past trend and assuming that will continue. When you think about it, that seems misguided. Risk is all about the unknown future, so how can its known history be a reliable indicator?

The past 20-25 years has thrown up many examples of such broader risks, some almost completely unexpected. There have been the usual - and more predictable - market events, notably, the ‘dot-com’ bust of 2000, but major risk surprises came with the Brexit referendum and US election results of 2016. More recently, in 2020, we had the once-in-a-century worldwide coronavirus pandemic. Overarching all of these has been the existential risk of climate change.

It all seems as if the infamous Murphy’s Law prevails: what can go wrong, will go wrong. That being so, what’s the point of taking any risk at all? Those risk-averse investors who put all of their money in bank deposits and government bonds can, surely, sleep better and have fewer worries than those of us holding equities and watching the prices gyrate every day?

Crash and burn
The answer lies in the earlier point that the higher the return is, the greater the risk. In other words, you have to embrace risk - within reason - in order to achieve a reasonable rate of return. This is best achieved with an investment portfolio that is both diversified and risk-weighted, as described above.

That prudent low-volatility (or low-risk) strategy can reduce short-term losses in a market downturn, while its long-term performance could, at least, match that from the market and is likely to outpace cash returns by a wide margin.

The graph, below, compares what happened to a notional pair of lower-risk and higher-risk investment portfolios in the 2000-03 dot-com crash and the Great Financial Crisis (GFC, 2007-09). On both occasions, the high-volatility portfolio suffered sharp falls while its low-volatility counterpart saw much smaller setbacks.

View attachment 155

Not only that, but the low-volatility portfolio delivered much better long-term returns. Its lead may have been only 0.9% a year but, had it been worth £1,000 in June 1973, it would have been valued 45 years later, in June 2018, at £139,601. That compares with just £96,971 for the high-risk strategy, a difference of no less than 44%.

This result seems to overturn the risk-reward trade-off, where taking less risk also means accepting a lower return. How can that happen?

Pledging my time
Time is the answer. The more of it that you have, the better chance your investments will perform well. Market crashes are temporary. They tend to happen every 10-12 years but are usually over in three years or less.

Over the 45 years measured in the chart, there were three such setbacks, being the two already mentioned plus another in 1972-74. That was a total of about nine years of falling share prices, far less than the balance of some 36 years during which share prices were mostly rising.

Given time, therefore, a lower-risk strategy not only reduces the damage from market downturns, but rewards you with a head start when prices resume their long-term climb.

The comparison reveals another truth about risk. Many undertake investment in shares and other assets mainly in order to make money. That approach puts the cart before the horse, because a prudent investment strategy must be based, first, on a thorough assessment of the risks. Only when those have been measured can you make a reasonable assessment of the likely return.

Or, as someone tweeted not so long ago: “It’s not about making a killing; it’s about not getting killed”.

I think the limit in this thinking is to focus too much on the asset price, and what really happens, to assess the risk.
Risk is the fact that more things can happen than will happen. It's the likelihood that the scenario you really want has one chance out of three of happening.
So diversification of what you have doesn't really work when you really, really need it to - we often say that it goes to 1 for every sector and market when the sh!t really hits the fan (see March 20)
Real risk mitigation is picking a good scenario that has 50% chance of happening rather than 20%, then pile on the position when it looks like you were right

 

[Shane H Norman1]

I think the limit in this thinking is to focus too much on the asset price, and what really happens, to assess the risk.
Risk is the fact that more things can happen than will happen. It's the likelihood that the scenario you really want has one chance out of three of happening.
So diversification of what you have doesn't really work when you really, really need it to - we often say that it goes to 1 for every sector and market when the sh!t really hits the fan (see March 20)
Real risk mitigation is picking a good scenario that has 50% chance of happening rather than 20%, then pile on the position when it looks like you were right

Indeed, R goes to 1 when something big happens that destroys investor confidence in general. Even then, however, an allocation to, for example, gold can help mitigate the resulting setbacks in shares and bonds, as it did when Russia invaded Ukraine and when covid struck.

I think your risk assessment example is much too optimistic. A 50/50 probability of winning isn't attractive enough, especially not for 'piling on the position'! In any case, as I said to Magellan, we should beware of reducing risk to a number: it gives a false sense of security.

Better to be sure of the value you are buying so that, if a singularity occurs and your selection tanks, you can buy more with some confidence.

 

[magellan1]

I don't agree with your argument that diversification leads to mediocre performance. Certainly, returns will be lower than those for the upper percentiles in a peer group; that's the cost of lower risk. But mediocre? The sample low-volatility portfolio I cited suggests otherwise, but I also call on Fama and French and their studies on the efficient frontier in diversification [EDIT: It seems another great mind was having the same thought as I composed this - thank you, JustAnotherHuman!].

On the other hand, as a lifelong contrarian and value investor, I'm deeply sympathetic to your point about Buffett and the concentrated Berkshire Hathaway portfolio. However, that approach requires really deep knowledge of each investment to counteract its higher risks. Few of us have the resources to acquire that. Even among professional investors, the strategy usually founders on the difficulty of persuading clients to buy into it (I've been there and have the scars). Buffett is, perhaps, the exception that proves the rule.

We're on the same page regarding volatility as a measure of risk. As I noted, risk is about the unknown future, so its known history can't be a reliable measure. Given another 1,000 words, I'd have expanded on that to emphasise that risk is not a number and, in another riff on Buffettism, I might have said that it's better to be approximately right than precisely wrong!

According to the existing academic research, close to maximum diversification can be achieved with 15 stocks. The higher the number of stocks in which one invests, the more similar his/her performance to the market indexes becomes but with higher costs (trading fees).
I believe that the number of stocks in one's portfolio should be a reflection of one's investment skills. On one side, beginner investors must buy the index or invest in many stocks (e.g. 30). On the other side, highly skilled and experienced investors like Warren Buffet should invest most of their capital in something like 10 stocks.

 

[HowardM1]

According to the existing academic research, close to maximum diversification can be achieved with 15 stocks. The higher the number of stocks in which one invests, the more similar his/her performance to the market indexes becomes but with higher costs (trading fees).
I believe that the number of stocks in one's portfolio should be a reflection of one's investment skills. On one side, beginner investors must buy the index or invest in many stocks (e.g. 30). On the other side, highly skilled and experienced investors like Warren Buffet should invest most of their capital it something like 10 stocks.

I guess it depends on how you measure diversification, a long only stock portfolio with diversify idiosyncratic risk but not systemic risk. So if the MCSI World falls sharply your portfolio will be correlated, it may of course have a different drift.

I'd agree to an extent with your view on large vs concentrated portfolio's if you have skill you certainly want a more concentrated portfolio particularly if you are truly bottom up as it would be hard to keep on top of 50 companies I would think.

 

[HowardM1]

Indeed, R goes to 1 when something big happens that destroys investor confidence in general. Even then, however, an allocation to, for example, gold can help mitigate the resulting setbacks in shares and bonds, as it did when Russia invaded Ukraine and when covid struck.

I think your risk assessment example is much too optimistic. A 50/50 probability of winning isn't attractive enough, especially not for 'piling on the position'! In any case, as I said to Magellan, we should beware of reducing risk to a number: it gives a false sense of security.

Better to be sure of the value you are buying so that, if a singularity occurs and your selection tanks, you can buy more with some confidence.

I think currencies offer more reliably offsets than gold (long usd, long chf and jpy for example), gold worked initially during covid but it then got smoked when margin calls on forced guys to sell what was liquid and take profit. So actually depending on how you define the covid episode gold did really poorly. Vix on the otherhand did pretty well. Short European banks was a pretty good hedge into Ukraine but also long commods, gold has benefited to an extent from that.

I have held gold in the past for diversification but always found it a frustrating trade.

As for probabilities of success a hit ratio of more than 50% is rare, more than 60% and your top decile, its not about your hit ratio its about your upside and downside capture. So you target a ratio if you can consistently deliver a 2 or 3:1 ratio then you can compound some serious returns. Smart diversification here can help but some don't bother with it at all and simply use a tight stop loss take profit framework.

 

[HowardM1]

Among professional investment managers, risk is defined, primarily, as a return that is either higher or lower than expected. A better-than-expected return is a risk? Absolutely. It usually means the investment is riskier than anticipated.

Ch-ch-ch-ch-changes
That’s because the higher the return, the greater the risk in terms of how often and how much asset prices move up or down, both in relation to the market (relative risk) or to a so-called risk-free investment such as cash or cash-equivalents (absolute risk). This is also called volatility.

View attachment 154

It measures the extent to which asset prices swing above and below their longer-term trend. It matters a lot to, for example, fund managers because a surge in the number of fund investors wanting to redeem might coincide, as often happens, with a major market setback, leaving the fund short of the necessary cash.

There are many investment types and instruments, each with its particular level of risk or volatility. A common illustration of this is the ‘risk pyramid’, with the riskiest investments at the top and the safest forming a wide base.

View attachment 156

Often, private investors focus only on the two lowest levels, thereby condemning themselves to low returns. At present, these don’t even compensate for the inflation that is continuously eating at the supposedly safe capital of the over-cautious.

On the other hand, no prudent investor should commit all of their money to the pyramid’s top levels.

The safety dance
The time-honoured methods for managing investment risk are, first, diversification, and, second, risk-weighting. The first entails investing across different assets (cash, bonds, equities, and real estate, for example), and/ or different markets (the USA, Japan, Germany, the UK, etc), and/ or different sectors (technology, retail, finance, and so on).

The purpose is to ensure that, even when some assets may experience price weakness, others may not and, overall, your investment portfolio will be less volatile and, therefore, safer. In short, diversification means not carrying all of your eggs in one basket.

Risk-weighting requires holding less of the riskier investments, with the majority of your holdings devoted to cash, bonds, and top-quality equities (‘blue chips’). For example, you might allocate 90 percent of your portfolio to blue chips, government bonds, and cash, but only 10 percent to property and crypto-assets.

Living in the past
However, the world of risk is much broader than simply the volatility of asset prices. Besides, volatility is measured by looking at its past trend and assuming that will continue. When you think about it, that seems misguided. Risk is all about the unknown future, so how can its known history be a reliable indicator?

The past 20-25 years has thrown up many examples of such broader risks, some almost completely unexpected. There have been the usual - and more predictable - market events, notably, the ‘dot-com’ bust of 2000, but major risk surprises came with the Brexit referendum and US election results of 2016. More recently, in 2020, we had the once-in-a-century worldwide coronavirus pandemic. Overarching all of these has been the existential risk of climate change.

It all seems as if the infamous Murphy’s Law prevails: what can go wrong, will go wrong. That being so, what’s the point of taking any risk at all? Those risk-averse investors who put all of their money in bank deposits and government bonds can, surely, sleep better and have fewer worries than those of us holding equities and watching the prices gyrate every day?

Crash and burn
The answer lies in the earlier point that the higher the return is, the greater the risk. In other words, you have to embrace risk - within reason - in order to achieve a reasonable rate of return. This is best achieved with an investment portfolio that is both diversified and risk-weighted, as described above.

That prudent low-volatility (or low-risk) strategy can reduce short-term losses in a market downturn, while its long-term performance could, at least, match that from the market and is likely to outpace cash returns by a wide margin.

The graph, below, compares what happened to a notional pair of lower-risk and higher-risk investment portfolios in the 2000-03 dot-com crash and the Great Financial Crisis (GFC, 2007-09). On both occasions, the high-volatility portfolio suffered sharp falls while its low-volatility counterpart saw much smaller setbacks.

View attachment 155

Not only that, but the low-volatility portfolio delivered much better long-term returns. Its lead may have been only 0.9% a year but, had it been worth £1,000 in June 1973, it would have been valued 45 years later, in June 2018, at £139,601. That compares with just £96,971 for the high-risk strategy, a difference of no less than 44%.

This result seems to overturn the risk-reward trade-off, where taking less risk also means accepting a lower return. How can that happen?

Pledging my time
Time is the answer. The more of it that you have, the better chance your investments will perform well. Market crashes are temporary. They tend to happen every 10-12 years but are usually over in three years or less.

Over the 45 years measured in the chart, there were three such setbacks, being the two already mentioned plus another in 1972-74. That was a total of about nine years of falling share prices, far less than the balance of some 36 years during which share prices were mostly rising.

Given time, therefore, a lower-risk strategy not only reduces the damage from market downturns, but rewards you with a head start when prices resume their long-term climb.

The comparison reveals another truth about risk. Many undertake investment in shares and other assets mainly in order to make money. That approach puts the cart before the horse, because a prudent investment strategy must be based, first, on a thorough assessment of the risks. Only when those have been measured can you make a reasonable assessment of the likely return.

Or, as someone tweeted not so long ago: “It’s not about making a killing; it’s about not getting killed”.

I left a long comment on this, then I realised actually its probably more interesting as a standalone article "The Myth of Minimum Vol" so keep an eye out for this, here is a summary of that article.

Numerous studies have debunked the myth of minimum volatility investing, revealing that high volatility alone does not predict poor future returns. In fact, it has been shown that high volatility stocks with low short interest can outperform a value-weighted index. On the other hand, high volatility stocks with high short interest tend to perform poorly, excluding outliers like the GameStop incident and other squeezes. Biases such as survivorship and selection can lead to misleading backtest results. For instance, a high volatility portfolio may be filled with low-quality stocks that have fat left-hand tails, which can be a drag on performance. Additionally, high volatility coupled with a negative drag can negatively compound. Conversely, low volatility stocks may have a lesser impact on volatility drag, even if some have a negative drift.

Investors should exercise caution when considering the minimum volatility approach and recognize the limitations of historical data. A more nuanced method of analysing stocks based on their individual merits is crucial for successful investing. As a final bonus point, a monkey throwing darts may outperform a market cap-weighted index over a long time period, suggesting that smart beta approaches do have value as opposed to simply buying an index tracker. But perhaps that's a topic for another article.

 

[Shane H Norman1]

According to the existing academic research, close to maximum diversification can be achieved with 15 stocks. The higher the number of stocks in which one invests, the more similar his/her performance to the market indexes becomes but with higher costs (trading fees).
I believe that the number of stocks in one's portfolio should be a reflection of one's investment skills. On one side, beginner investors must buy the index or invest in many stocks (e.g. 30). On the other side, highly skilled and experienced investors like Warren Buffet should invest most of their capital it something like 10 stocks.

I'd go a step further and say we should all invest the great majority of our assets passively, keeping no more than 10-20% for actively-selected opportunities. The record is clear: active managers rarely beat their passive counterparts, except in less-efficient markets such as mining shares or emerging markets.

 

[HowardM1]

I'd go a step further and say we should all invest the great majority of our assets passively, keeping no more than 10-20% for actively-selected opportunities. The record is clear: active managers rarely beat their passive counterparts, except in less-efficient markets such as mining shares or emerging markets.

The devil is in the details, though. How active is your passive strategy? I mean, you certainly don't want to buy a tracker on a market cap-weighted index. So you go the smart beta route, but what do you buy there—min vol, momentum, or a mix? That's an active bet right there. Also, have you evaluated the approach used by your chosen passive index provider? Because they are all different, which is another active decision. Finally, is your strategy a pure buy-and-hold, fire-and-forget approach, or will you be adding over time? How do you decide when to add to the investment, and do you have any rebalancing triggers? In the future, might there be something that makes you want to change your passive allocation?

My point is that there is really no such thing as a passive investing approach unless you literally buy something and lock it away for a fixed term. Even then, you made an active decision to buy.

I think a lot of laypeople use the term "passive" when what they really mean is buying beta rather than paying a manager to generate alpha. If we reframe it that way, I agree that for the majority of private investors, focusing on beta rather than alpha is likely to be a winning strategy in the long run. This is because the more volatile your portfolio, the more path-dependent it will become as you make decisions on hiring and firing alpha managers, and you are unlikely to be consistent in your methodology. It's far better to invest in beta and stay the course for the long run.

 

[Shane H Norman1]

I left a long comment on this, then I realised actually its probably more interesting as a standalone article "The Myth of Minimum Vol" so keep an eye out for this, here is a summary of that article.

Numerous studies have debunked the myth of minimum volatility investing, revealing that high volatility alone does not predict poor future returns. In fact, it has been shown that high volatility stocks with low short interest can outperform a value-weighted index. On the other hand, high volatility stocks with high short interest tend to perform poorly, excluding outliers like the GameStop incident and other squeezes. Biases such as survivorship and selection can lead to misleading backtest results. For instance, a high volatility portfolio may be filled with low-quality stocks that have fat left-hand tails, which can be a drag on performance. Additionally, high volatility coupled with a negative drag can negatively compound. Conversely, low volatility stocks may have a lesser impact on volatility drag, even if some have a negative drift.

Investors should exercise caution when considering the minimum volatility approach and recognize the limitations of historical data. A more nuanced method of analysing stocks based on their individual merits is crucial for successful investing. As a final bonus point, a monkey throwing darts may outperform a market cap-weighted index over a long time period, suggesting that smart beta approaches do have value as opposed to simply buying an index tracker. But perhaps that's a topic for another article.

I think any approach to investing that relies on a single measure, whether minimum volatility or whatever, is hobbled. High volatility should mean higher returns, but with greater risk. The key word here, and in my article, is risk, not volatility: the latter is merely one component of the former. If investors begin their selection process with risk assessment, they are making the right start.

I'm also wary of a purely technical approach. To succeed with investing, it should not be necessary to understand kurtosis, fat tails, or any of the Greek alphabet. Those might be useful for traders, but investors should seek good companies, with good products, secure markets, and honest, competent, management. For most of us, there just isn't time for all that, even if one has the inclination. Better, therefore, to have most of your assets in a low-fee tracker or ETF, keeping 10-20% for active opportunism in, say, emerging markets, small companies, tech, or whatever lights your fire.

 

[Shane H Norman1]

The devil is in the details, though. How active is your passive strategy? I mean, you certainly don't want to buy a tracker on a market cap-weighted index. So you go the smart beta route, but what do you buy there—min vol, momentum, or a mix? That's an active bet right there. Also, have you evaluated the approach used by your chosen passive index provider? Because they are all different, which is another active decision. Finally, is your strategy a pure buy-and-hold, fire-and-forget approach, or will you be adding over time? How do you decide when to add to the investment, and do you have any rebalancing triggers? In the future, might there be something that makes you want to change your passive allocation?

My point is that there is really no such thing as a passive investing approach unless you literally buy something and lock it away for a fixed term. Even then, you made an active decision to buy.

I think a lot of laypeople use the term "passive" when what they really mean is buying beta rather than paying a manager to generate alpha. If we reframe it that way, I agree that for the majority of private investors, focusing on beta rather than alpha is likely to be a winning strategy in the long run. This is because the more volatile your portfolio, the more path-dependent it will become as you make decisions on hiring and firing alpha managers, and you are unlikely to be consistent in your methodology. It's far better to invest in beta and stay the course for the long run.

Intellectually, that's all correct. But, who wants to be an investing intellectual, lecturing their mates down the pub about skew, EBITDA, and the Greek alphabet? I want a world in which every young person can, with confidence, invest a fixed portion of their earnings every month, or every quarter, in ETFs or other passive vehicles that track markets at the lowest-possible cost. Then, when they marry, buy a house, pay for a daughter's wedding, or retire, they will know they have the money to hand to do all of those things without worry.

THAT is the true purpose of investing. Everything else is financial self-abuse.

 

[HowardM1]

I think any approach to investing that relies on a single measure, whether minimum volatility or whatever, is hobbled. High volatility should mean higher returns, but with greater risk. The key word here, and in my article, is risk, not volatility: the latter is merely one component of the former. If investors begin their selection process with risk assessment, they are making the right start.

I'm also wary of a purely technical approach. To succeed with investing, it should not be necessary to understand kurtosis, fat tails, or any of the Greek alphabet. Those might be useful for traders, but investors should seek good companies, with good products, secure markets, and honest, competent, management. For most of us, there just isn't time for all that, even if one has the inclination. Better, therefore, to have most of your assets in a low-fee tracker or ETF, keeping 10-20% for active opportunism in, say, emerging markets, small companies, tech, or whatever lights your fire.

Of course its multi faceted.

This statement seems to be confusing: "High volatility should mean higher returns, but with greater risk." In finance, volatility typically refers to either realized or implied volatility, which measures how much a stock price moves within a given time frame. This concept is not directly related to potential or realized returns, which represent the drift of the stock over time. If you have a different definition in mind, I suggest using a different term to avoid confusion.

A stock can exhibit high volatility and move sideways with zero drift, resulting in a flat return. Alternatively, a stock can display low volatility and move with a positive upward drift.

When discussing risk as it relates to investing, it's essential to consider the underlying mathematics, such as distributions and time series analysis. This knowledge is not exclusive to traders and is not overly complex. Without a basic understanding of the math behind investments, you may be at a disadvantage.

Of course, one can discuss risk in terms of risk appetite etc on a more philosophical level without delving into details. However, as the saying goes, "You can't eat philosophy, Grasshopper."

 

[Shane H Norman1]

My point is that investing should not require this level of knowledge or analysis, just as buying a car doesn't require knowledge of how its engine works. You can acquire that knowledge if you're interested, but it's not essential. The post-boomer generations, robbed of defined-benefit pensions (unless they work for the government), are desperately under-invested in terms of the liabilities they face, specially retirement. They should be encouraged to save, save, save, so making it as simple as it actually can be is my mission.