What Risk Means

Risk is part of investing. It is unavoidable and it’s even sought after. Risk is clearly related to potential rewards. To achieve the largest possible returns, investors have to accept higher than average risk. Low risk is associated with low returns. While these basic principles are well understood, the meaning of risk is less well understood.

Professionals almost always tend to define risk in terms of standard deviations. This is frustrating because the idea of a standard deviation means nothing to most of us. If a financial adviser tells a client that portfolio risk is two standard deviations above average, that might either mean nothing to the investor or it might sound frightening, despite the fact that it sounds specific and scientific. Unfortunately, discussing risk in scientific terms can lead to poor decisions.

Studies from other fields indicate incomplete information can cause individuals to react in unintended ways that cause more harm than good.

The American Medical Association recently found television ads from lawyers seeking clients, who suffered complications from prescription drugs can harm patients. Many doctors report that patients who abruptly stop taking drugs after seeing an ad can face serious medical consequences. The ads simply list risks but ignore benefits. This study demonstrates how incomplete information can be more dangerous than a complete lack of information. The same conclusion can apply to risks investors face.

Investors commonly associate risk with volatility. This is certainly unfortunate because volatility can be experienced as prices rise or fall. Upward volatility is the goal of most traders, whether they realize it or not. Avoiding high volatility can mean reducing exposure to investments that deliver steady gains on the upside. At a minimum, measuring risk in terms of volatility is an incomplete measure and that has led to a number of other metrics to define risk.

One of the first efforts to refine the measurement of risk was the Sharpe Ratio, developed by Nobel Prize-winning economist William Sharpe. This ratio divides annualized returns by annualized risk and considers both risks and rewards.

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Technically, Sharpe subtracts the risk-free rate of return from the average annual return of the investment. The interest rate of 13-week Treasuries can be used as the risk-free rate of return. This step can be cancelled out because the same value of risk-free returns will be used in all calculations and ignoring it will not change the relative risk rankings of various investments. This mathematical reality resulted in a second measure of risk known as the information ratio.

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In both formulas, the denominator is risk measured in standard deviations. To help investors understand the amount of risk an investment carries, many advisers explain the Sharpe ratio or information ratio tells us how many units of reward we receive per unit of risk. Some even believe “good” investments have ratios greater than 1 and advise clients to look for this as a minimum requirement.

Sharpe ratios can be calculated for any investment including mutual funds, ETFs or individual stocks. This allows for a quick test of the idea of what a good Sharpe ratio should be. Almost everyone agrees that Warren Buffett is at least a “good” investor and he serves as a role model for many. His investment vehicle, Berkshire Hathaway (NYSE: BRK.A), has a Sharpe ratio of about 0.7. Blindly following the Sharpe ratio and requiring a ratio greater than 1 would have resulted in missing this investment.

This simple example highlights the problem with most measures of risk. Volatility on the upside is desirable. But an investment that beats the market on the upside and loses less on the downside could have a low Sharpe ratio. One metric that avoids this problem is the Calmar ratio.

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The Calmar ratio ignores the idea of volatility as standard deviations. Instead, risk is defined as the maximum drawdown in percentage terms. The maximum drawdown is the largest loss you’d have suffered in that investment. For example, if you owned an S&P 500 index fund for the last ten years, the maximum drawdown was about 55%. This provides meaningful information to an investor.

An S&P 500 index fund generally has a Sharpe ratio of 1 over the long term and sounds relatively benign with respect to risk. A drawdown of 55% tells you that risk can be life changing. Imagine you planned on retiring in March 2009. As an aggressive investor, you had about 60% of your account in stocks and the rest in bonds or cash. I’ll leave the math out of this article but assuming your fixed income investments gained 10% while your stocks lost 55%, your portfolio would decline by almost 30%. Most financial advisers believe your portfolio will generate annual retirement income equal to about 3% of the value of your account. That 55% drawdown results in 30% less income.

This is information you can use to make decisions. The Calmar ratio is probably the most useful measure of risk for most investors. To be conservative, you can estimate the maximum drawdown to be higher than the historic drawdown. When comparing different investment options, a higher Calmar ratio indicates an investment has been less risky during the period of time used in the calculation. Using this ratio, you can make better decisions about how much of your portfolio should be allocated to stocks.

While the Calmar ratio might be the best way to compare the risks of different investments, the formula measures just one aspect of risk. No ratio can precisely capture the risks associated with liquidity, news and market risk.

Liquidity is an important consideration for investors in individual stocks. If a stock typically trades with low volume, it might be difficult to sell during a market downturn. This doesn’t mean you won’t be able to sell. It just means it might be expensive to sell. When the market sells off, the spread of many illiquid stocks should be expected to increase and this can increase trading costs. The spread is the difference between the bid and ask prices.

You could wait for the market to bounce higher which should reduce trading costs. But if the stock is down because of news specific to that stock, you might not want to wait. A poor earnings report, for example, could lead to a quick selloff in a stock. But the stock might not rebound significantly since traders may expect more bad news to follow.

To avoid the risk associated with a single company such as a bad earnings report, most experts agree you should diversify investments. This is an excellent way to reduce risks but it also reduces returns. If you own too many stocks, large gains in one won’t have a significant impact on your portfolio. This means investors wanting to beat the market might want to consider limiting their diversification. Most studies show holding 10 to 15 stocks provides some benefits of diversification, while allowing a stock to contribute meaningfully to your returns.

Of course some risks can never be eliminated. Market risk, the risk of a selloff like the one that occurred in October 1987 or the bear market of 2008, can never be eliminated. In a bear market, most stocks will decline. Some studies show 80% or more of all individual stocks follow the broad market’s general trend. To avoid the risk of market-sized losses, stock selection is important. Buying stocks with limited risk should help lower losses even in the worst bear market.

It’s also important to remember no stock is likely to deliver gains forever. Risk increases with time and selling overvalued stocks when they turn down can be the best way to reduce risk.