There may be no word discussed more in the world of investing than “risk”. Risk means many different things to different people. To some, it represents how much a given investment might fluctuate in a given day, month, or year. To others, it represents the chance an investment might lose its value entirely. A third option is that risk represents the chance an investment or portfolio will suffer a permanent loss of capital that will never be recouped. At Baskin Wealth Management we typically discuss risk as the latter; and we believe it possible to significantly reduce the risk of permanently eroding one’s capital through diversification, wise asset allocation, and owning high quality investments.
An astute reader will note that all three of the above view only the possibility of an investment declining in value. But risk is a double-sided coin. While all investors face that risk, almost all will face the opposite as well – the risk that their portfolios will not earn enough of a return over time to meet their goals.
The concept of the risk vs. return trade-off in modern finance dates back to Harry Markowitz’s efficient portfolio, which explains, in brief, that investors prefer lower risk and higher returns, all else equal. This formed the basis for Modern Portfolio Theory, which further posits that for every level of return, there exists a portfolio with the lowest possible risk; an investor’s (or a portfolio manager’s) job is to pick the portfolio from that series of efficient portfolios.
The difficulty in choosing the correct portfolio arises from two factors. First, risk and return do not increase in a straight line. Past a certain point, increasing the portfolio’s expected return requires increasing volatility (or risk, by one definition) substantially. Second, each investor has unique needs and objectives which they hope their portfolio will be able to accommodate. The wise manager’s job is to determine how those objectives can be satisfied while taking as little risk as possible.
The rub lies in the phrase “as little risk as possible”. Like many problems, particularly in finance, having enough money can more or less solve an investor’s issues. An elderly investor with a frugal lifestyle and a $100 million portfolio can leave their money in a chequing account with zero chance of running out of funds. But most investors do not have that luxury, and may find themselves in a situation where the only realistic way for their portfolio to accommodate their needs is through earning profits, which would necessitate taking some risk; perhaps more than they would like.
For investors who lack a significant “safety net” in terms of the size of their portfolio, and particularly for investors years from retirement, sacrifices may need to be made. This can come in the form of cuts to their current or future expenses, or changes to asset allocation. Since reducing spending is itself frequently unpalatable (or even impossible), investors may have no choice but to take some risk with their investments in order to achieve an adequate rate of return.
While virtually every long-term investor wants to take as little risk as possible, taking too little risk can be as serious as taking too much. An investor whose portfolio does not earn enough profits can find their portfolio unable to accommodate their goals and would be forced to alter their objectives accordingly. A portfolio manager’s job is to strike the appropriate balance between achieving those goals without taking undue risk. We believe the only way to do this is to know our clients well with a deep understanding of their hopes and worries, while managing their portfolios prudently and intelligently. We work hard every day, striving to achieve both.