(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)
Here’s a favorite test question I would ask CFP® candidates when I taught the investments course: You have a 25 year-old client who just drove to your office in his classic 1985 Camaro IROC-Z and, not with the least bit of irony, who you’ve 
accurately determined to be extremely risk averse. Should you invest the client’s IRA in stocks or bonds?
Have you figured out the answer?
Yes, this is a trick question, but it’s trickier than you think.
If you answered correctly, you would have said the risk averse 25 year-old client’s IRA should be invested in stocks. If you’re a fiduciary, then placing the portfolio in stocks remains the only correct answer. Why? Isn’t the client always right? Well, if you’re a trustee – and, fundamentally, fiduciary rules derive from trust law – your “client” isn’t the 25 year-old of today, but the 59 ½ year-old beneficiary, i.e., the same person 34 ½ years from now. Whoa! Who knew being a fiduciary involved time travel?
Now, here’s where the tricky part comes. If you’re merely a broker, then both stocks and bonds can be suitable investments. Investing in bonds may not be in the 59 ½ year-old beneficiary’s best interests, but the 25 year-old probably will be happy. Satisfying the needs of the 25 year-old might be all one needs to meet the lower requirement of the suitability standard.
Why the difference? A fiduciary must always look out for the best interest of the client. In this case, the best interest involves investing in the asset class that has the potential to earn the highest return over the 34 ½ year period. When the choice lay only between stocks and bonds, then stocks win this battle hands down.
But what of the “risk-aversion” the 25 year-old went out of his way to make sure you understood? It’s irrelevant. What’s more relevant is that 25 year-old’s return requirement. Given the investor’s age, we assumed he needed to maximize his return. Of course, let’s say his return requirement is only 2% and 30-year government bonds pay 3%. In that case, a fiduciary might be able to justify investing in the 30-year government bond, but only if that 2% return requirement is rock solid (this might be a pretty big assumption over such a long time period).
Unfortunately, portions of the financial service industry tend to rely on the use of questionnaires to determine the personal risk aversion (or risk profile) of the individual investor. In some cases, laws appear to have practically mandated this (e.g., certain Prudent Investor Acts passed by some states in the 1990’s). This probably came about because of Modern Portfolio Theory’s “sound bite of the century” – “risk and return are related.” In addition, as part of the CFA Institute’s policies and standards, candidates and members are required to determine the client’s risk profile. Lawmakers likely just passed laws that reflected the then current industry and academic consensus. With the ascendency of behavioral finance, that consensus has since broken.
Here’s are the real problems with these risk profile questionnaires: They are so temptingly easy to place on a web-site and so alluringly “simple” to use and interpret, too many financial service providers offer them as a “value-added” basic and too many investors use them without question. Worse, by placing a subjective analysis into the false framework of a quantifiable questionnaire, investment firms give the illusion the results can be successfully mapped onto a “recommended” asset allocation. In turn, this gives investors a misleadingly false sense of comfort. Finally, and most detrimentally, as we learned in the opening paragraphs of this article, in many cases, an investor’s risk profile offers no relevance to the appropriate investment strategy.
As a result, financial service providers, including a portion acting as fiduciaries, use this risk profile questionnaire to determine an appropriate “risk-adjusted” asset allocation for their clients. The use of risk-adjusted measurements, while still popular, peaked with the high water mark of Modern Portfolio Theory in the 1990’s. Indeed, in 1997, Morgan Stanley created a system called “M-Squared” to measure the risk-adjusted returns of mutual funds. (“Morgan Stanley Pitches System to Measure Mutual Fund Risk” Wall Street Journal, February 7, 1997). That this measure employs return volatility statistics tells you all you need to know about the credibility of this technique. (If it doesn’t, then it’s suggested you re-read Part III of this series, “The 401k Plan Sponsor’s Dilemma – What’s Wrong With ‘Risk’.”)
If Caesar’s soothsayer were around today, he’d forsake warning of the Ides of March. Instead, he’d be walking the Forum ominously declaring, “Caesar, beware managers proclaiming risk-adjusted performance measurements.” Our eternal soothsayer no doubt would recognize such “measurements” require two very immeasurable assumptions: 1) a proper definition of real risk; and, 2) a world where risk really matters. Neither exists today and, while we might have a chance of someday actually defining the first, the latter will rarely ever be true.
Perhaps this has been too philosophical. Let’s break the argument down into something, well, road-tested. Here, we’ll introduce The Parable of the Best Car Value based on “Risk Adjusted” Cost.
Have you ever bought a car? If you haven’t, suffice it to say it’s a negotiation process. You should never pay the sticker price. You must always haggle. (Incidentally, this is one reason why I hate buying cars.) You might therefore conclude one of the primary risks when buying a car is paying far above the cost of the car. Clearly, a car will have more value if you pay only for the cost of the raw materials and labor that went into its assembly. With this in mind, we can then define the “Risk-Adjusted” Cost of a car by the following formula: Price Paid divided by Total Cost.
Let’s say the Total Cost of a Chevy Colorado Truck is $20,000 and the Total Cost of a Chevy Camaro ZL1 is $10,000. Paying $30,000 for the truck would have the same “Risk-Adjusted” Cost to the buyer as paying $15,000 for the Camaro. (According to our formula, both have a “Risk-Adjusted” Cost of 1.5.) To obey our theory, the buyer would purchase the vehicle with the lowest “Risk-Adjusted” Cost. So, if he can talk the dealer down to $14,000 for the Camaro, he’d drive that muscle car right out of the showroom.
But wait! What if our buyer really required a vehicle capable of moving construction material most effectively. Obviously, that buyer will throw our pretty little “Risk-Adjusted” Cost formula out of the window and buy the truck over the Camaro any day.
To better explain the folly of “Risk-Adjusted” formulas, let’s assume our buyer has no peculiar vehicular requirements. One can plainly see paying below cost is the buyer’s ultimate desire. Using our “Risk-Adjusted” Cost formula, we can easily determine that the most desirable “Risk-Adjusted” purchases would involve junk cars as no dealer in his right mind could afford to sell below cost. Alas, the cars with the best “Risk-Adjusted” cost all lack one slightly important trait – they can’t run!
What’s the lesson of this parable? “Risk-Adjusted” investment returns have no tangible meaning primarily because they assume a definition of risk that has no practical meaning. For the long term investor, staying at pace with or slightly beating one’s required return represents the only reasonable measure of investment performance. For the conservative (or common-sense) investor, risk is reduced by avoiding risky investments such as IPO’s, commodities, futures, options and companies without a history of strong financials. For 401k investors, that means choosing mutual funds that shun these risky investments. When analyzing the potential choices of 401k investment options, this is the kind of parameter that has the most meaning to the ERISA plan sponsor. Stochastic measures of risk have no meaning and only end up misleading both the fiduciary and the beneficiary.
Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 2nd Deadly Sin – The Joy of “Risk”
Part II: Investment Risk and the 401k Fiduciary: An Overview of Components
Part III: The 401k Plan Sponsor’s Dilemma – What’s Wrong With “Risk”
Part IV: Why Risk Doesn’t Matter to the ERISA Fiduciary
Part V: Risk and the 401k Investor: How Plan Sponsors Can Avoid Misleading Employees
Chris,
I appreciate the post, but your premise is fully reliant on a steady and always existent Equity Risk Premium and excludes all of the behavioral finance data that has been accumulated this past few decades. Stocks are “Risky” investments no matter when they are purchased because of their potential for large fluctuation – but they will not always return 5 – 6% real – valuation matters.
Finally, you state “risk is reduced by avoiding risky investments such as IPO’s, commodities, futures, options and companies without a history of strong financials.”
This statement is void of the facts. Commodities can reduce volatility and potentially increase return and options can be used to reduce risk when stocks become severely over-valued. My point is not that these investments aren’t risky – just that they have a place in a portfolio if used correctly. Finally, its actually the companies with poor financials that show a history of outperformance – of course, this is also dependent on current valuation.
I fail to understand how one builds a portfolio and ignores valuation. If there was a sudden demand for that Camaro such that the price tripled….maybe waiting to buy is a better idea. What you pay matters.
Scott:
Thanks for the comment! You’re absolutely right about the behavioral finance research – I was coming to that (remember, this series is part of a much broader series). In fact, since I wrote the third series before the first two series, the Equity Premium Puzzle is introduced in this installment: 401k Plan Sponsors Beware: Are You Lighting a Match in the Powder Room Despite 1995 Study? http://bit.ly/nlIi0w
The purpose of this series is to expose the flaws of the popular definition of risk. You’re ahead of the game in understanding how recent research in behavioral finance has shed light on these flaws. We’ll just have to wait for the rest of the industry to catch up!
And, yes, valuation does matter, but not for the purpose of this series of articles. Using standard deviation to define risk (the actual subject of this series) is unaffected by the actual valuation at any point in time. As an investor, of course valuation matters, as an author writing on a specific topic, past editors have always warned not to try to make too many points in one article. Not only does that make it easier for most readers, it also lengthens your writing career (after all, it gives you a reason to write more articles).
Thanks for reading and continue to add your comments – it’s the only way I’ll become a better writer!
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