Let’s start with a comparison of two relevant definitions.
Volatility is the likelihood of returns shifting quickly and unpredictably.
Risk is the chance of financial injury, damage, or loss.
Just a commonsense look at the definitions indicates the difference. It is possible, and often likely that a portfolio can be volatile, but not lead to any financial loss.
– James B. Cloonan
In last month’s article, we provided criteria for evaluating investment opportunities. This month, we come to understand why so many investors are using a flawed approach to grow their wealth.
Pie Chart Portfolios
It is our firm belief here at Concentus that most wealth, including (and perhaps especially) capital that is being professionally managed, is invested using a flawed understanding of how the capital markets really work.
To understand why we believe this, let us first consider a hypothetical investor, Mr. Joe Sixpack, whose long-lost wealthy aunt recently passed away and left him $5 million to invest. Because he doesn’t know anything about investing, Joe is in search of some honest financial advice. Regardless of whether Joe turns to a big national brokerage firm, a local money manager, an independent Registered Investment Advisor, or a discount firm like Vanguard, it is very likely that Joe will be offered a similar process for developing his long-term investment plan.
First, Joe will be asked to explain his financial and family situation, his short-term liquidity needs, and his long-term goals. Next, he will fill out a “Risk Tolerance” questionnaire, which will help to determine how much volatility he can tolerate in his portfolio. Finally, his friendly and professional advisor will present him with a recommendation for a “Pie Chart Portfolio,” a graphic presentation of the optimal portfolio allocation that will deliver him the most efficient risk/reward outcome for his portfolio over time. This presentation will probably feature a colorful pie chart, with individual “slices” representing precise percentage allocations to be invested in various asset classes and styles to achieve the desired result over time.
From that point forward, Joe’s portfolio will be identified by a description of his overall percentage asset allocation. In Joe’s case, he will become known as a “60/40 investor,” meaning that his optimal recommended portfolio mix should be 60 percent in stocks and 40 percent in bonds.
Modern Portfolio Theory
The vast majority of invested wealth in the world, and especially wealth that is professionally managed, is invested using the basics of a mathematical framework called “Modern Portfolio Theory,” which was developed in 1952 by an economist named Harry Markowitz. The centerpiece of this theory is a concept called “The Efficient Frontier,” which attempts to demonstrate the most “efficient” portfolios possible. This model provides a graphical interpretation of the portfolio allocations that will provide the greatest degree of expected return for the risk taken. An example is below.
Basically, this chart uses historical rate of return data to plot the risk/reward behavior we can expect for any given portfolio allocation. For example, if we study the long-term historical returns of a portfolio invested 60 percent in stocks and 40 percent in bonds, we find that the average annual return over time has been just north of 9.5 percent per year, but that the risk of that portfolio (as measured by the standard deviation of returns) is just about 11.5 percent. If we seek more return, we can go to 100 percent stocks and achieve a return of almost 11 percent per year, but in doing so we will take on more risk. On the other hand, if we wish to toggle down our risk to a less volatile blend, we must also accept lower returns. The Efficient Frontier is simply a graphical expression of the risk/reward characteristics of any given portfolio blend.
Are your eyes glazing over yet?
The Fatal Flaw
The Efficient Frontier, and its related Pie Chart Portfolio approach, is by far the most popular framework in the world for developing investment policy, and trillions of dollars are invested using this theory. Unfortunately, this theory is also fatally flawed in that it totally confuses risk with volatility.
Note the label on the horizontal axis on the graph above, which defines risk as “the standard deviation of annual returns.” In other words, this model is defining risk as the variability of annual investment returns over one year. While this is a great description of volatility, it certainly does not define risk, and it most certainly does not relate to investors’ experiences in the real world. In fact, risk should be defined as the chance that an investor will experience a permanent loss of capital over their investing time horizon, which may very well be considerably longer than one year.
The flaw in the Efficient Frontier is that it reduces all investors down to the single common denominator of a one-year investment time horizon. It does not provide an adequate understanding of the actual risk of loss over periods longer than one year, like the timeframe of most real-life investors. In the real world, most families invest for goals that are much longer term than one year, such as a new baby, or a grandchild going to college in 18 years, or a retirement lifestyle over a period of 30 years, or leaving a family legacy many years beyond that.
In the Real World
For long-term investors in the real world, perhaps a better approach to asset allocation is in order. Perhaps we should adopt a framework that reflects the risk/return relationships of various investments over longer time periods, which more closely approximate our desired investing timeframe, to achieve our goals. For long-term investors with real-world life goals, it is certainly possible that a portfolio can be volatile but not lead to a financial loss.
As a personal example, I started my career as a financial advisor back in 1993, and I started investing a few dollars a month into my 401k plan at my company. Those first dollars I invested into an S&P 500 Index Fund have grown by five-fold since 1993, despite the fact that I had to endure years like 2002, when the S&P 500 declined by 23 percent, and 2008, when the S&P 500 return was 38 percent. I have certainly experienced a great deal of variability of my individual annual returns over 25 years, but I now have five times as much money than I started with. I have experienced an amazing amount of volatility in my returns, but I definitely have not experienced actual risk.
When we study the risk/reward relationship of various investments over longer time periods, we find that the longer our time horizon, the more likely it is that equities will produce a superior return to any other asset, with a diminishing chance of actual real loss the longer we invest. Over the last 100 years, equities have produced an average annual return of just about 10 percent per year, and if we are lucky enough to have a 30 year or longer time horizon, our actual risk of permanent loss is very close to zero.
And no pie chart portfolio can measure up to that.