The risk of "riskless"

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Investment risks come in many different flavors. Some risks grab our attention like biting into a jalapeno pepper. Other risks are much more subtle.

Market volatility risk is like the jalapeno. It evokes strong emotions and is so compelling that entire cable channels are dedicated to following the minute-by-minute swings in stock prices. But sometimes volatility can blind us to more subtle risks--risks that may have even greater bearing on our long-term economic well-being.

Waking up to subtle risks

I learned this lesson as a young portfolio manager. My team was asked to help a major New York advertising agency revamp the investment strategy for its pension plan. The agency had just gone through an aggressive leveraged buy-outs and management worried that market volatility would leave their pension plan underfunded. My job was to reduce that risk by making sure their portfolio could hit its return targets.

To give you a little background, if a pension plan is “underfunded”—meaning it doesn’t have enough assets to meet its projected obligations—the company sponsoring the plan is required to contribute enough assets to make the plan solvent. Contributions to a pension plan reduce the company’s earnings, so companies generally try to minimize them. This is especially true when companies face other obligations like paying down massive amounts of bank debt.

As we evaluated various portfolio strategies, the managers at the agency kept pushing us to eliminate stocks from the portfolio. Stock market volatility scared them and they hoped eliminating stocks would increase the likelihood that the pension fund would stay properly funded. Unfortunately, that wasn’t the case at all. In fact, we found the more we reduced stocks in their portfolio, the more likely they were to have a funding shortfall.

At first, the results of our analysis puzzled me. I was so inculcated with the notion that volatility was risk and risk was volatility that I couldn't see what was happening. And then it struck me: no matter how we structured them, a portfolio of less-volatile investments like bonds and cash simply couldn’t produce enough return to satisfy the projected needs of the portfolio. By reducing volatility, they actually increased the key risk they were trying to eliminate. When I first realized what was going on, I remember feeling like I was waking up to a whole new world of risk.

As we shared our findings with management, they woke up to the fact that they faced a real dilemma. They could eliminate volatility by moving out of stocks and face a certain shortfall of definite proportions, or they could accept volatility and possibly avoid the shortfall altogether. After much soul-searching and corporate wrangling, they fortunately chose to accept volatility. In my time with that portfolio, they were able to keep up with their pension obligations.

Facing the dilemma

Many individual investors now face the same dilemma. Fearful of stock market volatililty, many have bailed out of stocks in favor of less volatile investments like bonds and money market funds. This reduction in volatility may feel good, but it comes at a price. With bond and money market yields at historically low levels, portfolios devoid of stocks simply cannot generate returns sufficient to meet most long-term goals. Their attempts to avoid risk have actually led to a massive increase in risk--it's just risk of a different flavor.

Some investors say they will return to stocks when market volatility subsides, but the record for market timers--even professionals--is not very good. Those who wait to own stocks until the market calms down, usually end up buying after the market has moved and then sell in frustration after the market rolls over. They are the "buy high, sell low" crowd.

A better way

We recommend a better way. Instead of centering portfolio risk management on volatility, we recommend identifying and managing the risks that matter most to you. This is why we are so strong on financial planning. A well-designed financial plan puts your financial life in perspective and helps identify the risks that truly matter. As I experienced in my work with the advertising agency, some of the most important risks you face may be much more subtle than near-term price volatility. Once those risks are identified, a suitable portfolio can be structured to help you accomplish your goals with the least amount of risk necessary.