Why Every 401k Fiduciary Should Redefine Risk as What Happens When You Miss Your Goal
Volatility never cut it in terms of defining investor risk. As we learned last week, the founders of Modern Portfolio Theory recognized the flaws of describing risk in terms of volatility. Volatility covered both ends of the risk/return trade-off. When volatility caused investors to miss their target, this was the realization of downside risk. When volatility caused investors to meet or exceed their target, this was the realization of upside potential.
That single term – volatility – stood to account for both the downside risk as well as the upside potential for any particular investment. That those responsible for creating MPT used this specific statistic to denote risk stands as their greatest failure. So close, yet so far.
We use the word “close” because the key for correctly identifying risk lies within the very components of volatility. We all know no one considers meeting or exceeding your goal as an example of risk. If anything, they’d call that the reward. On the other hand, most will agree, at the very least, risk can best be described as the chances you might miss your goal.
To the extent “risk” is meant to reflect an assessment of relative danger associated with undertaking a certain enterprise, then merely reducing it to the odds of missing your target understates its true significance.
Here’s what is meant.
Suppose you say your goal is to walk from Point A to Point B. In this case, tripping and falling anywhere between point A and Point B would be considered a failure to meet your goal. Let’s say you have a 10% chance of tripping. If you’re going to define risk just as the odds of failing, then you might say you have a 10% risk.
Does this sound simple? Does it sound easy to calculate?
It is. And that’s one of the attractions of using standard deviation, variance and all those fun statistical numbers. They possess that mathematical elegance and tantalizingly close to common-sense allure that the industry loves and their clients don’t hesitate to believe.
To dig deeper on the risk-return relationship, read: “401k Plan Sponsor & Participant Primer – The Risk-Return Tradeoff”
Except, again, there’s one nagging problem. It fails to accurate reflect the true sense of danger an investor might be in. To show this, we’ll return to our walking analogy.
We’ll keep the basic concept the same. The goal is to walk from Point A to Point B. Only this time, we present three different scenarios. In each scenario, though, the subject will walk on a similarly flat surface, so the probability of falling remains 10%. Here they are:
- In Scenario I, Subject I is walking on the floor.
- In Scenario II, Subject II is walking atop a string of sturdy three foot high boxes.
- In Scenario III, Subject III is walking on the sturdy ledge of a skyscraper thirty stories above the hustle and bustle below.
Which subject engages in the riskiest endeavor? Remember, they all have an equal chance of falling. If you were to use statistics similar to MPT, then you would say they all share the same risk. Unfortunately, if you’re like most people, to say they all share the same risk would be like hearing fingernails scratching along a blackboard. Despite the mathematical clarity of the shared 10% probability of failing, it just doesn’t feel right to say they each have the same risk.
Here’s why. What happens if they fail to meet their goal? If Subject I falls, the worst that could happen in most likelihood is that he’d twist his ankle. If Subject II falls, he just might break his leg. Finally, if Subject III falls, well let’s just say you don’t have to be a Wallanda to know what happens then.
Focusing on the consequences of failing to meet the goal rather than merely the odds of failing to meet the goal paints a very different picture when it comes to assessing risk. The probable outcome of failing to meet the goal looks like this: Subject I twists his ankle; Subject II breaks his leg; and, Subject III dies.
We’ll ask it again. Which subject engages in the riskiest endeavor? All of those who answered “Subject III” will immediately know why people fear of flying. Thus is revealed the new paradigm that begins to show how we should really define “risk.” Indeed, the term “risk” might not be the best word to use anymore. It will forever be associated with odds and probability – as well it should be. What it doesn’t connote is the clear assessment of danger this new paradigm must measure.
One other problem with MPT this new paradigm removes is the reliance on investment statistics as part of the individual investor equation. The new paradigm only requires the investor to define his goal and what’s needed to achieve that goal. That alone allows the investor to determine the true peril of failing to meet that goal. The variability of investments returns to its pre-MPT use as a tool, not part of the assessment.
What is this new system some of the leading investment advisers use today to work within the parameters of this new paradigm? Next week we’ll give it a name and tell you how these pioneers are using it right now.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.
Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the new definition of risk.