“Risk and return are related.” That was the soundbite of the 20th century, the mantra of Modern Portfolio Theory. Whether through those ubiquitous risk tolerance questionnaires or nearly any portfolio optimization software package, in one way or another, most professionals have been trained to use the mathematical equivalent of risk to plot investment strategies.
There's only one problem: It's all wrong.
Our use of risk fails in two ways. First, the industry has vastly misinterpreted the definition of the risk/return relationship. It has implied an absolute correlation between real risk and real returns exists. In truth, it's always been the perceived risk that's related to the expected return. Indeed, academic studies upon which many have based the use of risk tolerance questionnaires specifically warn against their use. Maybe the marketing guys forgot to read the fine print.
Second, the most popular measure of risk—standard deviation—is simply incorrect. An artifact of a lack of computing resources at the outset of the MPT era. Harry Markowitz, the father of MPT, admitted long ago he'd prefer to have used the semi-variance, but for the fact his computers didn't have the capacity to handle the processing load. In fact, standard deviation, which reflects the variance both above and below the mean, measures both downside risk and upside potential. That means it's just as incorrect to say standard deviation measures returns as it is to say it measure risk.
Worse, standard deviation's relevance depends on the location of the mean. The mean isn't necessarily the goal. Translation: Money market funds have the smallest standard deviation (ergo, the least risk), yet one would never invest long-term retirement assets in such a low return investment vehicle. But let's not stop there. “Risk”—the odds of hitting or missing your goal—just isn't that important. What is important is the consequence of missing your goal.
Think of it this way. Say your goal is to walk from Point A to Point B. You have a 10 percent chance of tripping (i.e., failing to meet your goal). How risky is that? It seems pretty low. But now let's say you have two different situations. Both possess the same 10 percent chance of failure and both involve walking on a 2 ½ foot wide slab of solid concrete. The only difference: One slab is a sidewalk on the street of a quiet rural town; the other slab is a building ledge 50 stories high in the air.
Now which situation presents the most risk? By definition, they both have a 10 percent risk of failure. Obviously, however, the ledge walker is in greater peril than the sidewalk walker.
Risk doesn't matter. What matters is achieving your goal. Retirement investors' risk tolerance is irrelevant. They need to know the average rate of return they must earn every year to achieve retirement readiness. I call that their “goal-oriented target” and I encourage all financial advisors to ignore everything they've ever learned about risk and keep their eyes on their clients' goal-oriented targets.
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Christopher Carosa
Chris Carosa has been writing a weekly article and monthly column for BenefitsPRO online and BenefitsPRO Magazine since 2011 and is a nationally recognized award-winning writer, researcher and speaker. He’s written seven books, including From Cradle to Retire: The Child IRA; Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort; A Pizza The Action: Everything I Ever Learned About Business I Learned By Working in a Pizza Stand at the Erie County Fair; and the widely acclaimed 401(k) Fiduciary Solutions. Carosa is also Chief Contributing Editor of the authoritative trade journal FiduciaryNews.com and publisher of the Mendon-Honeoye Falls-Lima Sentinel, a weekly community newspaper he founded in 1989. Currently serving as President of the National Society of Newspaper Columnists and with more than 1,000 articles published in various publications, he appears regularly in the national media. A “parallel” entrepreneur, he actively runs a handful of businesses, including a small boutique investment adviser, providing hands-on experience for his writing. A trained astrophysicist, he also holds an MBA and has been designated a Certified Trust and Financial Advisor. Share your thoughts and story ideas with him through Facebook (https://www.facebook.com/christophercarosa/)and Twitter (https://twitter.com/ChrisCarosa).
