Measuring the risks of investments
Kyle Tetting: Chris, we spend a lot of time talking about market corrections. We spend a lot of time talking about the potential for portfolio declines, but I think what we really care about is how we measure some of those risks.
Ultimately, we have tools like standard deviation and beta, tools we use to talk about how much a portfolio bounces around or how much it bounces around relative to a benchmark. They’re great tools, but they have some issues.
Chris Evers: Yes. Standard deviation and beta are great tools in that they’re agnostic to the sources of risk. They incorporate a lot of data within those two tools. They give you an idea of price variance in the bouncing around of stock funds, bond funds or your portfolio as a whole.
But the issue with standard deviation and beta is that they’re entirely based on past price history, so all they really can incorporate is things that have occurred in the past that have affected the prices of those assets. So, they’re not always great at forward looking or handling unprecedented situations that maybe haven’t happened in price in the past.
Kyle: And I think when we talk about risk, we need to differentiate between this idea of sources of risk — that the economy falters, the meteors from outer space that are potential sources — and the way we measure. And as we talk about measuring really as the idea here, when we look at individual positions, there’s ways to get even more involved other than just simply looking at how something bounces around. Maybe talk about bonds a little bit, some of the ideas we use there?
Chris: If we get more granular and go into the bond side of the portfolio and say, “Well, how do we measure risk in bonds?” Well, there’s really two main tools that we like to utilize, and that’s duration and credit risk or credit ratings. So, if we start first with duration, what duration is telling us is how sensitive is your bond or bond portfolio to changes in interest rates? Now, what’s different from standard deviation and beta and why duration is a great tool is it’s actually prescriptive of forward looking. So, it’s not telling you what has this fund done in the past, or this bond done in the past, in terms of reacting to price data, but it instead says if this situation occurs, if we do have an increase in interest rates, what can I expect to happen to my bond portfolio?
So, that’s very useful because it’s a forward-looking measure. In many ways, a credit risk is also a forward-looking measure. Credit agencies are giving triple-A, double-A, single-A, different ratings to bonds out there, which signal, OK, this is what the balance sheet looks like for this business, this is what their cash flows look like. And that can give you a sense for how likely is default for this business. Generally speaking, the lower the credit rating, the higher the default risk. So we can use those tools to get an idea of what to expect going forward.
Kyle: That’s great on the bond side. And certainly I think what we often view as the more risky asset, stocks, standard deviation and beta, which we talked about, are a great kind of introductory lesson. But I think there are some more instructive measures out there.
Chris: I think we should take it a step further on the stock side. I think a lot of people just still rely a lot of times on standard deviation and beta. They’re useful measures, but they’re not very intuitive or relatable to investors. So let’s say, for example, I told you the standard deviation of a stock fund is 13%. It doesn’t really mean a lot to people. They don’t really understand what that means going forward and what can I expect from this fund. So, a tool I like to use is max drawdown.
So, for example, if we were to look at this stock fund and say in its peak-to-trough worst time period in history, it lost 28%. Well, that gives you a little bit of color of what you could expect in a bad scenario for this fund. That gives you a better idea of going forward, here’s the risk that I’m taking if things don’t play out or if we enter a market environment that’s not anticipated. So it gives you a little bit more color to just the 13% standard deviation number, which doesn’t really give you much.
Kyle: I think, Chris, we talk often about, again, these sources of risk. But as we look at the measures of risk, why is it so important that investors have some of these tools?
Chris: Well, the tools are important because you don’t want to dive into water without knowing how deep that lake is. You’ve got to get a feel for what’s around you. And as you build a portfolio, by having these measures of risk, whether that’s duration or credit risk or standard deviation or worst drawdown, you can get a feel for where are the sources of risk in my portfolio and where can I balance these out? You’re constantly measuring risk against the potential for return.
So, for example, if we took bonds: If I’m told that the interest rate yield on this bond is 3% and I have a duration of 2, well, I’d have an idea that if interest rates moved up 1%, I might lose 2% on the face value of that bond, but I’m getting 3% for the interest yield. So, now I can measure and say, “Well, is that a fair trade-off in my book?” Otherwise, you really don’t know what your trade-offs are making. So measuring these risks gives you an idea of what the trade-offs are going forward so you can make decisions with open eyes.
Kyle: And of course, put all this together, right. So we’ve got different measures for bonds, different measures for stocks, different ways that investors should think about measuring risk in their portfolio. And ultimately, that’s the kind of thing that we use to build a truly diversified and balanced portfolio. Without the ability to measure those things, you lose the ability to really understand how those fit together.
Chris: Absolutely. You need to be able to observe the standard deviation of individual positions but understand how that plays out in a portfolio as a whole. So, a big part of modern portfolio theory is understanding that you could add two different holdings that have higher standard deviations, but if they’re not correlated or they don’t react in the same manner and go up and down in different times, well, you could actually lower the standard deviation of the entire portfolio by combining these assets.
So, that’s what we’re looking to do, right? We’re trying to add assets that are not going to react the same to various market environments and have different sources of risk, so that you’re not putting all of your risk on one bet, whether that’s interest rates or whether that’s credit or whether that’s the cyclicality of the markets. You want to make sure that you have assets that’ll perform differently in different market environments.
Kyle: Chris, thank you for joining us today.
Chris: Thank you for having me, Kyle.
Chris Evers is a registered representative at Landaas & Company.
Kyle Tetting is research director at Landaas & Company.
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(initially posted November 26, 2021)