RISK INVERSION

In an investment context, risk is loosely defined as the probability of losing the value of your investments. Essentially, you won’t have the amount of money you need at the time you need it.

There are many people (mostly academics) who view every investment decision through the lens of risk, estimated by volatility, beta, or exposure to downside outcomes. For these folks, investment risk is approximated from a probability distribution, much like the ones below.

The theoretical application of charts, graphs, and models are useful in understanding basic principles but often fail to account for human nature and behavior. Real life is not as well-defined as any model would lead you to believe.

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Sources of Risk

The primary risks for long-term investors are typically macroeconomic in scale.

1. Risks related to the economy, like recessions and depressions.

2. Risks related to the government, like changes in tax policy, increasing/decreasing regulation, or just poor governmental policy and management.

3. Risks related to the consumer like slow wage growth and heavy inflation. The rising concerns of stagflation (limited growth AND high inflation) are currently coming into focus.

These real sources of risk are often the most misunderstood. All of the above are complex topics without an easy solution. If someone believes that there is a quick solution to any of these issues, they don’t actually understand the problem at hand.

Because of the complexity of risk (the root cause of the risky environment), it is easy to be tempted to focus on the headlines, market commentary, or the concerns of well-meaning but naive friends. Like a flashing neon sign in the night, the market turns on and off each day, drawing in countless eyes and mind share.

The daily grind of the market wants our attention. The large moves up and down are easy to publicize. Since the real measures of risk are macro in scale and difficult to estimate, there are other measures attempting to track the market’s movement and gauge the overall level of risk at any given moment.

Volatility and the VIX

There are a number of measures for volatility but chief among them is the VIX. When the VIX is high, it is generally interpreted to be a volatile environment. When the VIX is low, traders would expect the market to be less volatile.

The VIX is a core focus for short-term investors and traders because the most significant impact of volatility is not realized until the sale of an asset has been made. This also means that volatility is typically more poignant for a retiree who is slowly liquidating investments to produce retirement income or other short-term investors.

For investors with long time horizons who are not yet retired, the volatility associated with a declining market should warrant little or no concern. A bear market is simply a period of time to accumulate shares at a discounted price.

I am not breaking news or discovering some trend in regards to utilizing the VIX as a market indicator. Other experts have said, “When the VIX is high, it is time to buy.” A wealth manager and CNBC contributor, Josh Brown, has taken a special interest in certain VIX ranges leading to buying opportunities.

By looking at a chart of the VIX and keeping in mind times when the market was in a tailspin, there seems to be at least some correlation between good times to buy and a heightened VIX.

Loosely speaking, the VIX is an accumulation of all investors’ perception of risk in the current moment. It is an interesting tool but does not effectively reflect the actual risks in the environment.

Investing in a Risky Environment

Our perception of risk is retroactive, but in reality managing risk is a proactive activity.

This means that you will be most concerned about risk when the environment is inherently less risky. It will feel like the world is ending because of falling markets and economic turmoil, but the opportunity to proactively manage risk has already passed. Thoughts and conversations about risk will be at the forefront when it is already too late.

As the market and environment reaches its highest point in regards to risk, chances are you won’t even be aware of it. Everything will look and feel great, and the overall environment will seem steady. Markets will be slowly ticking upward, often reaching new highs. Yet, the risks you can’t see or anticipate are slowly rising too.

For the vast majority of investors, little should change. The short-term risk environment should have little impact on your overall strategy. The mantra “Just Keep Buying” developed by Nick Magiulli should be top of mind. The success of your investing activities will be determined by your consistency and long-term growth.

It is important to recognize though that there are elements within your control.

Risk and You

By nature, risk cannot be entirely avoided. That being said, effective financial planning becomes a tool to manage or reduce risk.

Risk management is a proactive activity. There are things you can do for yourself, alongside a friend, or with a professional advisor to manage risk and your perception of it.

Create clarity through meaningful objectives. You have the opportunity to define goals and desired outcomes. If you view a bear market as an opportunity to put dollars to work in your financial plan, the short-term volatility within the market is less relevant.

Understand your inclinations and behaviors. If you are the type of person who worries about anything and everything, there is no need to watch daily investment news or regularly check account statements. Don’t allow short-term concerns to steal your attention. Your plan and focus should be oriented around daily/weekly/annual market movements.

Diversify. There is no reason to unnecessarily expose yourself to risk. Diversification is a simple way to help preserve what you have built.

Save more and spend less. If the greatest risk is needing funds but not having them, additional savings can mitigate this risk. Most people regret not saving enough or not starting early enough. Saving and thoughtfully managing expenses is an easy way to proactively minimize regret and mitigate risk.

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TL;DR

Our perception of risk does not actually track along with the actual level of risk in the market. Instead, it closely follows the noise in the market.

The real sources of risk are complex and essentially unavoidable. The measures of risk we see on a day-to-day basis are poor estimates of real risk and can even be an indication of a buying opportunity.

For most investors, a "risky" environment and the corresponding volatility is simply an opportunity to accumulate a share of the market at a discount. The financial planning elements (long-term goal planning, mitigating behavioral biases, diversification, and cash flow) should be the areas of focus, not active and/or drastic investment management.

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When did you feel as though market risk had reached its peak, or will it reach that point soon? Are you willing to “put money to work” when the market is down? Do you have a strategy for investing in volatile markets?

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