Defining Your Investment Risks

A clear picture of your risk tolerance is essential.

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Tim Lee

The term “risk management” is a bit like the term “happiness”—everyone wants it, but few can define what it really means.

Following the 2008 financial crisis and the ensuing stock market rebound, many investors are now trying to get a firm grasp on the meaning of risk. Without a clear definition, managing risk is essentially impossible for many investors. However, there are some highly effective approaches for both defining and managing risk. I’ll lay out the basics below.

The dictionary definition of risk is simple, and also unhelpful: “Risk is the exposure to the chance of injury or loss.” That’s obviously too broad for most investors. On the other end of the scale, large institutional investors have used a complicated version of a fairly simple concept for many years called “value at risk” or “VaR”. VaR is essentially a measurement of the probability of a risk of loss on a given asset or portfolio of assets. There are entire teams of mathematicians employed on Wall Street whose only role is to define this term, and to do so in a highly specific way. This definition is to going to be too specific and complicated for most investors. For us to use the definition, it needs to be specific but still broadly applicable.

In my experience, a more effective definition of risk will break out specific types of risks into component parts, which lets us to focus on the true cost of an adverse outcome, and then mitigate the specific downside risks one at a time. Among others, investors face the following key risks—price risk, liquidity risk, geopolitical risk (terror attack, etc.), interest rate risk, inflation risk, political risk, default or credit risk, exchange rate risk and operations risk.

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In our financial advisory practice, we've devised a process which allows us to strike a happy medium between the broad “chance of injury or loss” and specificity of a mathematically derived measure of that chance of loss on a portfolio of financial assets. We call it “The Triangle.” Essentially, it mimics Maslow's hierarchy of needs, and is broken into three blocks: Survival, lifestyle and legacy. These three areas relate not only to assets, but just as importantly to liabilities. In other words, we help our clients to identify, categorize and then organize their assets and their expenses and liabilities (or future expenses discounted into current liabilities) which provides a simple breakdown of the funding source for any given expense or cost.

This breakdown of expenses and funding then allows us to match investment strategies and asset allocations to the appropriate level of risk for any given spending need. Obviously, this requires at least a basic current budget and a guess about future costs and expenses. Generally, those data points are easy to estimate. Additionally, it is typically easy to assign a timeline and likely range to any of the various expense categories. For example, “survival” costs like food, clothing, healthcare and shelter are expenses which are immediate, recur almost every day and are non-negotiable. In contrast, a “lifestyle” expense like a vacation trip is something that is generally planned in advance, is flexible in terms of costs and can be negotiated or adjusted. Finally, a “legacy” budget item such as the cost of college education for your children is something you can plan for years into the future, and can have a great degree of flexibility.

The value of this approach is that it allows for the creation of “risk budgets” for any portfolio allocation. In other words, what we are better able to determine what level of various risks (e.g., price, liquidity, or interest rate) is appropriate for that portion of the overall asset pool. For example, we use low-volatility assets like short-duration or floating-rate bonds to offset the shortest term and recurring expense needs. These assets tend to be stable, but have potential low rates of return. As we go up the triangle to “lifestyle” costs we use more volatile assets like stocks, commodities and REITs, which historically have tended to perform well over longer periods of time, despite short periods of poor performance. Finally, with the longest-dated expenses or assets to be passed on to the next generation we use illiquid assets like directly-owned real estate, 529 plans or a private business, which are expected to produce strong long-term returns, though often have short-term costs and poor liquidity.

This process has also helped us to combat the age-old cycle of fear versus greed, which historically has driven unproductive investor behavior of selling low and buying high. By defining and segmenting a budget for each of the three blocks of the triangle, we are able to more effectively align the allocation of the portfolio with the reality of spending needs. Additionally, we are able to rebalance as the different parts of the portfolio perform over time.

While it’s not as simple as an online calculator, by breaking the various parts of spending and assets into smaller, more definable targets, it becomes much easier.

At the end of the day, we believe that a detailed and complete financial planning process will allow you to define your desired outcome, and with that understanding, make more informed and thereby ultimately more effective decisions.

Timothy R. Lee, CFP®, is a Managing Director and co-founder of Alexandria, VA-based Monument Wealth Management, a full service wealth management firm located in the Washington, DC area. Tim and the rest of the Monument Wealth Management team can be followed on their blog at "Off The Wall", on Twitter @MonumentWealth, and on their Facebook page.