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"It is only the price on the final day that counts." — Warren Buffett
Three weeks ago, I introduced the concept of behavioral portfolio management (BPM) as a way to build superior portfolios. The next week, I discussed the first basic principle underlying BPM: Emotional crowds dominate market pricing and volatility. Last week, I presented the second basic principle underlying BPM: Behavioral-data investors can earn excess returns.
In this article, the fourth in a series of five, I will discuss the third and final basic principle: Investment risk is the chance of underperformance.
What is BPM?
BPM posits that there are two categories of financial market participants: emotional crowds and behavioral-data investors (BDIs). Emotional crowds are made up of investors who base decisions on anecdotal evidence and emotional reactions to unfolding events. Human evolution hardwires us for short-term loss aversion and social validation, which are the underlying drivers of today’s emotional crowds. On the other hand, BDIs thoroughly and extensively analyze behaviorally driven price distortions and build portfolios based on these distortions.
Basic principle III: Investment risk is the chance of underperformance
The measures currently used within the investment industry to capture investment risk are really mostly measures of emotion. In order to deal with what is really important, let’s redefine investment risk as the chance of underperformance. As Buffett suggests, focus on the final outcome and not on the path travelled to get there.
The suggestion that investment risk be measured as the chance of underperformance is intuitively appealing to many investors. In fact, this measure of risk is widely used in a number of industries. For example, in industrial applications, the risk of underperformance is measured by the probability that a component, unit or service will fail. Natural and manmade disasters use such a measure of risk. In each situation, the focus is on the chances that various final outcomes might occur. In general, the path to the outcome is less important and has little influence on the measure of risk.
In an earlier article I reviewed the evidence regarding stock market volatility and showed that most volatility stems from crowds overreacting to information. Indeed, almost no volatility can be explained by changes in underlying economic fundamentals at the market and individual stock levels. Volatility measures emotions, not necessarily investment risk. This is also true of other measures of risk, such as downside standard deviation, maximum drawdown and downside capture.
But unfortunately, the investment industry has adopted this same volatility as a risk measure that, rather than focusing on the final outcome, focuses on the bumpiness of the ride. A less bumpy ride is thought to be less risky, regardless of the final outcome. This leads to the unintended consequence of building portfolios that result in lower terminal wealth and, surprisingly, higher risk.
This happens because the industry mistakenly builds portfolios that minimize short-term volatility relative to long-term returns, placing emotion at the very heart of the long-horizon portfolio construction process. This approach is popular because it legitimizes the emotional reaction of investors to short-term volatility.
Thus risk and volatility are frequently thought of as being interchangeable. However, focusing on short-term volatility when building long horizon portfolios can have the unintended consequence of actually increasing investment risk. Since risk is the chance of underperformance, focusing on short-term volatility will often lead to investing in lower expected return markets with little impact on long-term volatility.1 Lowering expected portfolio return in an effort to reduce short-term volatility actually increases the chance of underperformance, which means increasing risk.
A clear example of this is the comparison of long-term stock and bond returns. Stocks dramatically outperform bonds over the long run. By investing in bonds rather than stocks, short-term volatility is reduced at the expense of decreasing long-term wealth. Equating short-term volatility with risk leads to inferior long-horizon portfolios.
The cost of equating risk and emotional volatility can be seen in other areas as well. Many investors pull out of the stock market when faced with heightened volatility. But research shows this is exactly when they should remain in the market and even increase their stock holdings, as subsequent returns are higher on average.2 It is also the case that many investors exit after market declines only to miss the subsequent rebounds. Following the 2008 market crash, investors withdrew billions of dollars from equity mutual funds during a period in which the stock market more than doubled.
The end result is that investors frequently suffer the pain of losses without capturing the subsequent gains. Several studies confirm that the typical equity mutual fund investor earns a return substantially less than the fund return because of poorly timed movements in and out of the fund. Again, these are the dangers of not carefully distinguishing emotions from risk and thus allowing emotions to drive investment decisions.
Measuring underperformance
In order to measure investment risk, it is necessary to properly define underperformance. Underperformance depends on both the time horizon of the investment and the goal of the investor. For example, if the goal is to have $100,000 in two years, risk is measured as the chance of ending up with less than $100,000 in two years. In this case, short-term volatility is an important contributor to risk.
In the cases where there is no specific time horizon, the appropriate benchmark is the highest expected return investment being considered. The actual return should approximate the expected return over long time periods, due to the law of large numbers. Most long-term investment situations fall into the this category.
Note that short-term volatility plays an ever-smaller role as the time horizon lengthens. This is because the short-term emotionally and economically driven price changes tend to offset one another over the long run by means of time diversification. Markets experience about one third to one quarter of the volatility over the long-term as compared to the short-term.
1. Higher return variance lowers an investment’s long-term compound return, but this impact is small compared to the impact of investing in lower expected return markets.
2. See French, Schwert, and Stambaugh (1987).
Sources of investment risk
Moving beyond emotions, the sources of investment risk are well known. At the micro level, events such as default, company failure and company mistakes contribute to risk. Diversification can mitigate these to a large extent. At the macro level, the economy and government policies contribute to systematic risks. These risks are more difficult to address since they impact a large number of industries and companies. These micro and macro risks are generally taken into consideration by BDIs but not necessarily well understood by the emotional crowd.
There is another risk component that actually grows over time, what I call foundational risk, which is often overlooked. This is the risk of countrywide economic or stock market failure. History reveals that this risk is real, with numerous economic and market failures occurring though the centuries. Foundational risk increases over time, just as the risk of an earthquake increases as the time period lengthens. One must account for this risk when making investment decisions.
Behavioral science tells us that individuals either underestimate or overestimate foundational risk. The probability of such an event happening is low (neither has happened in the U.S. during its 235+ year history), so many assume this probability to be zero, which of course it is not. On the other hand, if a low-probability event has happened recently, individuals tend to overestimate these risks. The recession of 2008, while not an economic or market failure, was a reminder that such occurrences are possible even in a country as economically advanced as the U.S. So now many investors overestimate this risk by building portfolios as if such failures are imminent. It takes real discipline to properly estimate this risk in light of emotionally charged events like 2008.
Assimilating basic principle III
This principle is the most difficult for investors to assimilate. It involves redirecting the powerful emotion of short-term loss aversion and acting contrary to the hard-wired need for social validation. For a number of investors, this may simply be too much to ask. But for others, progress may be possible.
A first step is calling things as they are. Rather than labeling everything risk, be careful to identify and separate that portion which is really emotion. There are risks that must be taken into account when making investment decisions. But don’t muddy the water by carelessly lumping emotions and investment risk together into a single number, as is the case for many currently popular risk measures.
A flying analogy illustrates this separation process. All of us who fly have experienced turbulence, which can range from unnerving to downright frightening. When asked about their flights, many travelers will comment on the amount of turbulence they encountered. But we know from years of FAA research that turbulence rarely causes injury or death. Instead, pilot error and other human errors are the leading causes of plane crashes.
What if the FAA had listened to passengers to determine the risk of flying? Rather than meticulously studying each accident and uncovering the true cause, the FAA would have spent considerable time trying to reduce turbulence, as requested by passengers, thus missing the critical role of human error in accidents. By focusing on short-term turbulence, they would have actually made flying more dangerous. But they did not and as a result we have just experienced the safest year in commercial flight since the dawn of the jet age.
We are not so fortunate in the investment industry. Rather than carefully separating risk from emotions, the industry provides a mixed bag of risk measures that exacerbate the emotional aspects of investing. So advisors, in allaying the fears of clients, find it necessary to disregard conventional wisdom. Thus they must confront both clients and the investment establishment in order to successfully overcome the emotional challenges of successful investing.
Volatility and advisor/fund business risk
Short-term emotional volatility is potentially more of a problem for the advisor/fund than is investment risk. Advisors and funds see revenues decline when client short-term investment performance is poor, and in the extreme case, investors may leave to invest elsewhere. This is an important reason why the industry lumps emotional risk into currently popular risk measures.
When an advisor or fund states that an investment is risky, based on currently popular measures, they are actually saying three distinctly different things:
- There is considerable emotionally-charged volatility with this investment.
- Because of this, there is substantial business risk for my firm.
- Oh, by the way, there is some amount of investment risk.
Only investment risk matters for making decisions, particularly for long-horizon portfolios. But these three types of risk are emotionally interconnected and it requires considerable effort to pull them apart. The first step is to correctly label each component: client emotional reaction to volatility, advisor or fund business risk and investment risk.
Conclusion
Ample evidence supports the argument that emotional crowds dominate market pricing and volatility. This makes it possible to build portfolios that harness the resulting price distortions. But many investors will find this process difficult, since the emotional barrier of social validation must be overcome in order to build successful BDI portfolios.
As a step towards overcoming these emotional challenges, it is important to carefully distinguish between emotions and investment risk when constructing portfolios. To accomplish this, redefine risk as the chance of underperformance rather than as short-term volatility. Focus on the final outcome rather than on the emotional path to that outcome.
In the last article in this series, I will discuss the specific things that can be done to build portfolios that take advantage of emotional pricing distortions and earn superior returns.
C. Thomas Howard is Professor Emeritus, Reiman School of Finance, Daniels College of Business, University of Denver and CEO and Director of Research, AthenaInvest, Inc.
Contact information: [email protected] (877) 430-5675 x100. A longer version of Behavioral Portfolio Management can be obtained at the Social Sciences Research Network website.
Read more articles by C. Thomas Howard, PhD
