AAII Journal Editor
Focus on Risk
Long-term investors should focus on their risk tolerance.
Interpreting the Sharpe Ratio
A measure of reward relative to volatility.
AAII Discussion Boards
How Do You Define Investing Risk?
This week’s AAII Sentiment Survey results:
Bullish: 42.6%, down 4.7 points
Neutral: 29.8%, up 5.4 points
Bearish: 27.5%, down 0.7 points
November 21, 2013
November 14, 2013
November 7, 2013
October 31, 2013
October 24, 2013
October 17, 2013
October 10, 2013
October 3, 2013
September 26, 2013
September 19, 2013
September 12, 2013
September 5, 2013
August 29, 2013
August 22, 2013
August 15, 2013
August 8, 2013
August 1, 2013
July 18, 2013
July 11, 2013
July 4, 2013
June 27, 2013
June 20, 2013
June 13, 2013
June 6, 2013
May 30, 2013
May 23, 2013
May 16, 2013
May 9, 2013
May 2, 2013
April 25, 2013
April 18, 2013
April 11, 2013
April 4, 2013
Before I start this week’s commentary, I want to quickly mention that AAII founder and chairman James Cloonan was featured in the Wall Street Journal last weekend. (A subscription is required to see the article.) Columnist Jason Zweig spoke with Jim about why he started AAII in 1978 and why individual investors now have more advantages than they did 35 years ago.
Risk seems like a word that is easily definable. Certainly, in the world of finance, explaining what risk is should be fairly straightforward. In reality, defining risk is a bit like defining obscenity—a person knows it when he sees it.
The Merriam-Webster Unabridged Dictionary lists four definitions, and several qualifiers, for risk. They include “the possibility of loss, injury, disadvantage, or destruction,” “someone or something that creates or suggests a hazard or adverse chance” and “the product of the amount that may be lost and the probability of losing it.”
Most individual investors would probably define risk as the chance of seeing their portfolios drop in terms of absolute dollars. If a portfolio has a certain possibility of falling from $1.00 million to $800,000, many investors would describe the portfolio’s investments as being risky. Notice my usage of “absolute dollars.” If the same portfolio appreciates 2% to $1.02 million, but inflation increases by 3%, the investor’s ability to buy goods and services is diminished. He incurs a loss in real (post-inflation) dollars, even though he avoided what he traditionally thinks as risk, meaning a loss of absolute dollars.
Institutional investors also have a hard time finding a consensus on how to define risk. In a list of his top investment peeves, hedge fund manager Clifford Asness argues that “risk is the chance you are wrong.” In his opinion, “risk control is limiting how bad it could be if you are wrong. In other words, it’s about how widely reality may differ from your forecast.” However, even Asness concedes the viewpoint of risk being the chance of a permanent loss of capital as “one fair way to think of risk.” (You can see his full argument about risk and his other top peeves in the Financial Analysts Journal )
Much of Asness’ argument centers explaining why risk is different than volatility. While I disagree with his explanation that volatility is how different actual returns are from forecasts, I do agree that risk and volatility are different. Volatility is a measurement of fluctuations in an security’s price, not whether a security rose or fell in price. In a rising market, volatility can be an investors friend; in a falling market, it isn’t. Volatility is a characteristic of a price return that leads to a loss of capital, but risk is the possibility of losing purchasing power.
Adding complexity to the definition of risk is time. Our brains are programmed to feel the pain of short-term losses. Yet even a 75-year-old may need his portfolio to last an additional 25 years or longer. Over such time periods, the risk of incurring a loss over the short term pales in comparison to the risk of not having enough money in the future to maintain an adequate level of purchasing power.
This is ultimately where one’s perception of risk needs to be focused: How much you are impacting long-term risk by your various short-term decisions. It’s admittedly not an easy way of thinking. We all have short-term needs and concerns, whereas the future is more difficult to mentally grasp. Yet the mistakes made over the short term have a compounded impact on the financial risk you will incur in the distant future. This is why once you satisfy your current financial needs, your biggest financial risk is unintentionally reducing your future purchasing power by being too focused on short-term market performance.
More on AAII.com
- For Long-Term Investors, the Focus Should Be on Risk – This 2005 AAII Journal article explains why you should take into consideration your ability to tolerate losses from uncertain returns.
- Interpreting the Sharpe Ratio – This measure shows whether an investor is being compensated for taking on additional volatility.
- Lifetime Investment Strategy – Jim Cloonan explains risk further and how it relates to return.
- How Do You Define Investing Risk? – Tell us on the AAII.com discussion boards.
- Don’t forget to take the Sentiment Survey.
The Week Ahead
Just a handful of S&P 500 members will report earnings next week: PVH Corp (PVH) on Monday, AutoZone (AZO) on Tuesday, Costco Wholesale (COST) and Joy Global (JOY) on Wednesday, and Adobe Systems (ADBE) on Thursday.
The first economic reports of note will not be appearing until Thursday, when November retail sales, November import and export prices, and October business inventories are released. Friday will feature the November Producer Price Index (PPI).
St. Louis Federal Reserve Bank president James Bullard and Dallas president Richard Fisher will both speak on Monday.
The Treasury Department will auction $30 billion of three-year notes onTuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year notes on Thursday.
AAII Sentiment Survey
More than four out 10 individual investors remain optimistic about the short-term direction of stock prices, according to the latest AAII Sentiment Survey. Fewer AAII members said they were optimistic than a week ago, however.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.7 percentage points to 42.6%. Even with the decline, this is the seventh time in the past nine weeks that optimism is above 40%. The historical average is 39.0%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged, rose 5.4 percentage points to 29.8%. This is the second consecutive week that neutral sentiment is below its historical average of 30.5%.
Bearish sentiment, expectations that stock prices will fall over the next six months, declined 0.7 percentage points to 27.5%. Pessimism is below its historical average of 30.5% for the eighth consecutive week and the 11th out of the past 13 weeks.
Four consecutive days of declines in the Dow Jones industrial average and the S&P 500 lowered the level of short-term optimism, but only minimally impacted short-term pessimism. Many individual investors continue to be encouraged by the market’s overall upward momentum, earnings growth and economic growth, while others are concerned about the pace of economic growth, elevated stock valuations and the lack of a long-term fiscal solution.
This week’s special question asked AAII members if the average consumer is now financially stronger or weaker than a year ago. Slightly more than half (51%) of all respondents thought the average consumer is now stronger. One in five of these respondents clarified their opinion by saying the average consumer is only slightly or marginally stronger. Approximately 21% of all respondents said the average consumer is weaker than a year ago, while 10% said the average consumer is unchanged.
During the week of Thanksgiving, we asked AAII members if holiday shopping or holiday travel data provide more insight into the health of the economy. By a three-to-one margin, respondents said holiday shopping was the better indicator. Several respondents described holiday shopping as encompassing a larger portion of the population. Some respondents also said that family trips over the holiday may occur even if consumers are otherwise reducing their spending.
AAII Asset Allocation Survey
November Asset Allocation Survey results:
64.2%, down 2.1 points
17.3%, up 0.4 points
18.5%, up 1.6 points
Asset Allocation Survey details:
29.6%, down 1.1 points
34.7%, down 0.9 points
13.9%, up 0.4 points
Allocations to stocks and stock funds declined last month after having reached a six-year high in October, according to the November AAII Asset Allocation Survey. Fixed income and cash allocations both increased.
Stock and stock fund allocations declined 2.1% to 64.2%. November was the eighth consecutive month, and the 10th out of the past 11, with equity allocations above their historical average of 60%.
Bond and bond fund allocations increased by 0.4 percentage points to 17.3%. Though it is the second consecutive monthly increase, fixed income allocations are only back to their August 2013 levels. Bond and bond fund allocations have now been above their historical average of 16% for 52 out of the last 53 months.
Cash allocation rebounded by 1.6 percentage points to 18.5%. Even with the increase, November was the eighth month in the past 11 months with a cash allocation reading below 20%. November was also the 24th consecutive month with cash allocation below its historical average of 24%.
The record highs set by the Dow Jones industrial average and the S&P 500 are also contributing to the above-average equity allocations, and many individual investors are hopeful the rally will continue. Stock allocations did decline during the middle of the month, however, in part due to a dip in sentiment about the short-term direction of stock prices. Some AAII members also continue to fret about the macro environment (slow economic growth, fiscal uncertainty, elevated stock valuations, etc.).
November’s special question asked AAII members what percentage of their portfolio they allot to index mutual funds and ETFs. Approximately 28% of respondents said index funds account for between 1% and 25% of their portfolios. An additional 24% of respondents said they did not own any index funds. Slightly more than 19% of respondents use index funds for between 26% and 50% of their portfolios. At the other end of the spectrum, nearly 11% of respondents said index funds compose between 75% and 99% of their portfolios, and 8% solely used index funds.