When assessing investment risk, it's wise to consider if you are emotionally prepared for what could be a wide range of possible outcomes. 

SMI executive editor Mark Biller talked about that on yesterday's MoneyWise Live on Moody Radio.

To listen, click the play button below — or, if you prefer, scroll down for a transcript. (For more radio appearances by members of the SMI team, visit our Resources page.)

MoneyWise Live, with hosts Rob West and Steve Moore, airs daily at 4:00 p.m. ET/3:00 CT.

To ask a question on a future program, call 1-800-525-7000 and mention you have a question for either Mark Biller or Matt Bell of Sound Mind Investing.


Transcript

Steve Moore:  You've heard it said, the greater the risk, the greater the reward. Now that might be a good strategy for playing monopoly, but we're investing. A better approach might be to ask what's the worst that could happen?

Rob West:  Our guest. Mark Miller is executive editor over at Sound Mind Investing, where it seems the number crunchers have been working overtime on bell curves and something called "tail events" — and I trust Mark can simplify all of this.

Rob West:  I have no doubt that he can, Steve — and Mark, welcome back to MoneyWise Live.

Mark Biller:  Thanks, guys. Good to be here.

Rob West:  Most investors think of risk as simply the chance they'll lose money on a particular stock or mutual fund or investment. But there's a bit more to it than that, right Mark?

Mark Biller:  Yeah, that's right. There are different types of investing risks, so it's really easy for misunderstandings to create problems for investors. For example, let's say that I read an article that says "market risk declined last year." Now based on that, I might assume that my investments are safer now — when the author may have simply been making the specific point that market volatility was lower than usual last year.

So you can see the potential to misinterpret here. Just because volatility decline doesn't mean that our investments are necessarily any safer going forward. So really the first key is to understand that when risk is being discussed in an investment context, what's often being measured is the volatility of an investment. In other words, how much does its return vary over time? Now, stocks — whose returns vary a lot — they have higher volatility. While bonds have lower volatility. And it is appropriate to think of stocks as being riskier than bonds based on that measurement of volatility.

Rob West:  Yeah, exactly. So most investors translate volatility to mean risk, but your article points out that volatility is actually good for certain decisions, not so great for others. Talk to us about that.

Mark Biller:  Yeah. So these technical measures of risk, whether we're talking about — volatility, "standard deviation," or we use an internal metric at SMI that we call "relative risk" — all these technical measures, they're primarily useful as tools to compare competing types of investments. So say you're comparing two different mutual funds, knowing these types of risk measurements can be really helpful in deciding which one to buy.

I'll give you an example. When we're recommending funds in our newsletter, if I'm choosing between two funds that have similar historical returns, but one has earned those returns with much lower volatility than the other, I'm almost always going to choose that lower-volatility option. So it's not that these technical risk measures are worthless, it's just that they're incomplete. They might help me steer between different stock funds, but they're not necessarily going to help me much with the question of "How much should I have invested in stocks in the first place?" 

Rob West:  Yeah, great point. So what's the broader view of risk that we should think about for those bigger-picture issues? We've got just about a minute before the break so we won't be able to unpack this fully, but get us started in thinking about the big picture here.

Mark Biller:  Well, a really good start is to think about ranges instead of historical average, which is what most investors focus on. So it's generally true that long-term returns do go up as risk increases, and that risk-return trade-off is really the basis of how we put together portfolios — trying to balance risk and return by adding and subtracting different types of assets.

The problem is a lot of investors just lock into those historical averages and take it as gospel. So they might kind of hear what the 60/40 long-term averages and just assume, "Well, that's what I'm going to earn every year if I have that type of portfolio." And what we're saying is instead of just focusing on that expected average, we need to look at the expected range of returns that increases along with risk.


Rob West:  This is a fascinating discussion. You know, as Mark said, so often we get fixated on historical averages as we're evaluating our investment portfolios or individual investment selections. But what about the range? And that really speaks to the risk, and the range of returns increases along with risk. And we need to recognize that.

You know, this is where really an illustration, Mark, I think is so powerful. So let me just encourage our listeners to go to soundmindinvesting.org and look at the illustration in this article we're referencing today, Two Types of Risk, so you can see a bit more about what we're talking about.

But I think the big picture is to recognize the broader range of possibilities as risk increases. And one way to do this is to never lose sight of the worst-case scenario. I know we don't want to think about that Mark, but that's important, isn't it?

Mark Biller:  You know, I don't want to encourage listeners to become pessimists, because in investing history usually favors the optimists over time. But basically, all we're saying here is investors should always at least consider the likelihood of a permanent loss of capital. So as opposed to these "technical" risk measures, this is more of an idea than a precise measurement. But keeping in mind the potential that a given investment has to cause deep losses can really save you from falling into these traps that we're talking about — that traditional risk measurements sometimes gloss over.

And I'll give you a simple practical example of that. Say you're evaluating a risky investment or strategy, you want to not be overly awed by the really impressive historic rate of return that it's earned. Instead, you want to focus probably just as much attention on what the worst-case scenarios have been for that particular investment.

So, you know, it might be great that it has this awesome historic return, but if this investment tends to lose 50-to-80% of its value once or twice a decade, you really need to think carefully if that's an investment that you can live with in your portfolio.

Rob West:  Mark, how should the current market situation affect the way we consider risk?

Mark Biller:  Yeah, we think that an investor's time horizon really should be a primary guide as to whether their focus is mainly on the market's long-term average returns or the market's range of potential outcomes.

To be more specific, if you're a younger person with decades of investing ahead, then it's much easier — and probably wise — to focus primarily on those long-term averages and not get too concerned about what the current market situation looks like. But if you're planning to retire soon, or you're already retired, then you want to pay a little bit more attention to this range of outcomes that we're talking about and balance that against those long-term returns, because older folks may not have time to recover from these worst-case type losses.

You know, I'm sure you've seen it, Rob, we certainly have over the years here: There's nothing sadder than seeing an investor cross their finish line more than once — meaning first going forward as they meet their goals and their portfolio is growing during a long bull market like we've had the last decade, but then again crossing through that finish line going backwards when a bear market arrives and reclaims a big chunk of those gains because they never dialed down the risk in their portfolio.

Rob West:  So what might that be in terms of somebody who is fully allocated to equities, or stocks? What downside risk should they be willing to take, even though the time horizon would say they can wait it out, just to check themselves to make sure that they're not going to react emotionally if that were to be the case.

Mark Biller:  Yeah. You know, there's kind of a big picture idea here and that is simply that for almost all investors as they get older, they should be taking risk gradually lower by reducing the portion of their portfolio in equities and increasing the portion of their portfolio and safer investments like bonds and other fixed income.

Now, of course, from individual to individual, that's going to vary because situations vary. For some folks, you know that 401(k) may be the only investments that they have to get them through retirement. So they're going to need to be more cautious than someone who maybe has other assets and other things they can draw from and can take on a little bit more risk.

So there's kind of a big-picture, general prescription for everybody to reduce the risk as you get closer to retirement. But then there is also a personal, you know, "risk tolerance" — that yours may be a little different from mine — and that's where an advisor or a service like SMI can certainly help you fine-tune that a little bit.

Rob West:  Mark, we have just a few seconds left. I'd love for your quick thoughts on the flip side of this and that is there's really a danger of being too conservative as well, isn't there?

Mark Biller:  Yeah, there absolutely is. So you have to balance all of this against that other form of risk which is being so conservative that you failed to meet your long-term goals, and really that's what makes investing so challenging. So you just have to always keep in mind the potential that next year may not look like this year and try to keep that big-picture perspective.

Rob West:  Very good. Mark, always great to have you with us, my friend.

Mark Biller:  Thanks, guys. Good to be with you.

Steve Moore:  Thanks, Mark. Mark Biller, executive editor at Sound Mind Investing. You can read more about today's topic in the article Two Types of Risk at soundmindinvesting.org. And we'll be right back after this.