One of the objectives of an investment strategy is to minimize or mitigate risk. The word risk is so simple and straightforward that we tend to overlook it, our minds skipping past it to focus on more interesting concepts like gathering alpha and tactical rebalancing. But is risk so straightforward? Risk can mean a lot of different things, and the way you view risk should impact how you build your portfolio to mitigate it.
The investment industry tends to conflate “risk” with “volatility,” using the two words almost interchangeably. But volatility — the up and down fluctuations in value of an investment — is only one type of risk. Measuring risk only with volatility metrics such as standard deviation disregards the other types of risk that investors face, which include:
- Not generating enough return to meet investment objectives over a time horizon
- A permanent loss of capital on a total portfolio basis or on a single investment
- Performing below peers
- Performing below an indexed portfolio that has the same objective
- An inability to meet liquidity needs or longer-term spending and/or distribution needs
- Underperforming relative to inflation
- Headline risk – the risk that an investment is reported on negatively in the news
When creating an Investment Policy Statement, we think it’s essential to identify and examine the chief risks that concern the investor. How a person or organization views risk should inform the construction of their portfolio, with a strategy that addresses those risks. For example, if you were most concerned about underperforming relative to inflation, your portfolio would look different than that of someone most concerned about losing principal.
While there is no way to eliminate investment risk, you can focus in on the types of risk that are most important to you, developing a strategy tailored to your tolerance and objectives.