Risky Business: Why Investors Need to Discuss Risk

The financial world has many ways to talk about risk—alpha, beta, Sharpe ratio and so on—but at the end of the day, how much do investors, or frankly most financial professionals, really understand about these terms? The answer is, not much.

No one really understands risk, so investors don’t talk about it and the consequences are significant. Only one in four clients say their financial advisor has talked about how much their investments may decline if the market crashes, per an investor survey by FinMason, a financial technology firm.

We like to think we are different and constantly talk about the risk factors in the market using tools like our recent resource report on maximum drawdown.

We need to talk… about risk.

There is no good reason for investors to avoid the discussion about risk. Unless you predominately use passive investments in which case you should avoid the risk discussion like the plague since the results are a tough pill to swallow!

People think about risk and reward trade-offs nearly every day, most often outside of the context of the investment markets.

Consider these choices:

• “Should I buy life insurance?” People weigh the risk of paying too much premium for a life policy, versus the reward of knowing their beneficiaries get some degree of financial protection.
• “What should my car insurance deductible be?” You may reward yourself with lower premiums by choosing a higher deductible, but you risk paying more out of pocket if you have an accident.
• “Should I go to the gym or stay on my couch?” You risk the poor health consequences of a sedentary lifestyle for the reward of easy entertainment.

I think all the sophisticated ways to measure and discuss investment risk make the discussion more complicated. The one risk measurement investors should care about the most (whether you realize it or not) is maximum drawdown risk—how much can you potentially lose in a catastrophic market downturn?

Keep it simple stupid…

To us, maximum drawdown is the only risk barometer that really matters, for two primary reasons: First, maximum drawdown is easy for investors to understand—it’s all about how much pain you are willing to endure to seek adequate returns.

Second, maximum drawdown can’t be changed, obscured, hidden or beautified by other performance statistics. With any peak-to-trough drop in investment value, what you see is what you get. There’s no hiding or smoothing over the consequences of a significant loss.

For example, let’s look at the performance of one of the biggest funds in the market, Dodge & Cox Stock Fund (DODGX), during the years of the financial crisis and Great Recession (2007-09). Looking only at calendar years, this fund suffered a -43% decline in 2008, falling along with the overall stock market and most other stock funds, but rebounded with a 31% gain in 2009.

What these annual returns can’t hide is the whopping -63% maximum drawdown this fund suffered from its peak in 2007 to its trough in 2009.

The question that every investor should ask themselves is, “Am I willing to tolerate the pain of a -63% drop in the value of your investment?” or even simpler “Am I ok with losing -63 % of my investment at any given time?”

Only the most aggressive investors would answer yes to this question yet trillions of dollars have recently poured into passive investments. In our opinion the aggressive investor is usually the first to freak out and sell everything, at the worst possible time. Most investors would recoil in pain over a catastrophic loss of this magnitude and be averse to investing their money at this level of risk.

How Potomac can help.

That’s why we believe a tactical strategy to manage risk and avoid catastrophic losses is suitable for all investors. (That would even include the most aggressive investors, when they’re ready to dial down their greedy impulses.)

We also believe all investors should put maximum drawdown at the forefront of any discussions about risk management. Using the pain of significant losses to frame the discussion about investment risk can help investors provide honest assessments of their true risk tolerance and select an appropriate investment strategy.

We published a resource report on maximum drawdowns for advisors to use with their clients. It shares more examples of the impact that drawdowns and catastrophic losses can have on investment portfolios to help investors get a better sense of their true risk tolerance.