The Ragged RockRisk in Retirement Investing
And the ragged rock in the restless waters,
Waves wash over it, fogs conceal it;
On a halcyon day it is merely a monument,
In navigable weather it is always a seamark
To lay a course by: but in the sombre season
Or the sudden fury is what it always was.
TS Eliot–The Dry Salvages
I wrote this article in 2008 at the height of the financial meltdown. I am presenting it pretty much intact as a reminder of what can happen. I wrote it more as a guide to those who were in initial or mid-stages of their careers and preparing for retirement. But it certainly applies to all of us who are retired and need to safeguard our assets as well.
These are the words of TS Eliot in the poem, The Dry Salvages. There is no better description for risk, or at least for the human perception of and attitude toward risk. On the first page of his introduction to “Against the Gods” Peter Bernstein calls the “mastery of risk” “the revolutionary idea that defines the boundary between modern times and the past”. Sounds like a halcyon day to me. Surely the sudden financial fury struck in September 2008. The subprime mortgage crisis metastasized and brought down Lehman Brothers, Bear Sterns and Merrill Lynch. It forced a government takeover of Fannie Mae and Freddie Mac. The US Treasury had to save AIG, Citigroup, Bank of America and a host of smaller banks in order to prevent the total collapse of the financial system. Washington Mutual became the largest bank failure in US history. We also saw the disappearance of Countrywide Credit and Wachovia Bank. And in this debacle individual investors and pension funds lost an estimated two trillion dollars of their retirement savings. The entire global financial system foundered on the ragged rock and risk was surely seen for what it always was. I doubt that we can legitimately claim to have mastered risk.
Therefore, everyone saving for retirement will inevitably encounter more such sudden financial fury in his or her investment “lifetime” of 40 to 60 years. In such turbulent times, people tend make all kinds of emotionally driven moves, often to their financial detriment. They suffer unrecoverable losses; dump stocks; flee to bonds and cash; or even stop investing for their future. As an investor you need to be well anchored to get through these financial storms with minimal damage. You need to build and outfit your financial ship by understanding and controlling risk in order to withstand the sudden fury.
Risk is one of John Bogle’s controllable factors. I would amend that to say that you can control your exposure to risk. But first you must recognize risk and have some understanding of it. When it comes to risk, certainly “waves wash over it, fogs conceal it”. This is a more poetic way of saying as Burton Malkiel did in A Random Walk Down Wall Street: “Risk is a most slippery and elusive concept”. Risk remains a philosophical problem. It involves predicting the future, which is really impossible. We try to measure it, generally by looking backward. Risk is measured most commonly by volatility or the standard deviation of past returns.
You cannot eliminate risk, so it is best to try to account for it. We can start with a dictionary definition of risk as “the possibility of suffering harm or loss.” Some idea of the potential issues facing investors that might cause loss can be seen in the risks enumerated in prospectuses. These are extracted from a couple sample prospectuses (Vanguard and PIMCO). For stocks the list includes market risk, investment style risk, industry concentration risk, manager risk, country risk, currency risk. Common risks for bond investors include Interest Rate Risk, Credit Risk, High Yield Risk, Market Risk, Issuer Risk, Liquidity Risk, Derivatives Risk, Equity Risk, Mortgage-Related and Other Asset-Backed Risk, Foreign (non-U.S.) Investment Risk, Emerging Markets Risk, Currency Risk, Issuer Non-Diversification Risk, Leveraging Risk, Management Risk, and Short Sale Risk.
The enumeration of risks in a typical mutual fund prospectus usually takes several pages. This is there largely to satisfy SEC requirements, but there is substance to it. I wonder how many people really take the time to read and absorb what is in the prospectus. I can tell that I used to look at the return data and look for the funds with the highest returns over the past five years. I didn’t spend much time looking at the list of risks. You need to spend as much time reviewing the risks as you do reviewing the rewards.
Below, I have listed several categories of risk without attempting to quantify the risk itself. I don’t know that this list is exhaustive of all kinds of risk, but it is a good start. I think that in assessing any investment, the investor needs to run down the list of risks and see how the risk categories apply to the particular investment.
- Volatility risk (the extent to which returns vary); this was evident big time during in 2008. We all expect some ups and downs. Fortunately for all of us the stock market and real estate markets have recovered for the most part.
- Bubble risk (the risk that many investors chase a certain asset class and make it more prone to a sudden bust); We saw this in the late 90’s and into 2000 with the internet bubble that suddenly went bust. And again I might add with the housing bubble. Everybody was piling on.
- Leverage risk (which multiplies both gains and losses);
- Liquidity risk (the chance that an asset cannot be sold quickly at the prevailing price); All too clearly this risk emerged in 2008 with toxic assets. The auction rate securities market was supposed to be as good as cash. But when the meltdown came some investors could not get their money out.
- Currency risk We certainly live in a connected world these days. Shifts in relative values of currencies can have a significant effect, positive and negative, on dollar-based investments.
- Transparency risk (if the investment structure is too complex to understand, it is too risky); We saw this with the “toxic assets” and credit derivatives that banks and other financial firms had on their books.
- Sensitivity risk to the overall equity market, and bond market; Pretty much everything went down in September of 2008. Treasury bonds proved to be the only real safe haven.
- Event risk (the danger an unforeseen event could pose); this is Donald Rumsfeld’s unknown unknown.
- Operational risk, which includes various risks of businesses failing to perform; This is particularly the case with individual stocks. But it also applies to bonds. If a company goes bust, the stock become worthless but the bondholders may get only pennies on the dollar. It applies even to municipal bonds. If a source of revenue dries up, then the bonds can devalue quickly.
- Political risk—government decisions can have a huge influence; Expect government decisions to play a larger role in the aftermath of the financial meltdown. In China, the government runs the banks. Look at the situation today in countries such as Russia, Brazil and Venezuela.
- Market risk—investor safeguards, rule of law, market transparency, public information availability. If you are investing in emerging markets that have little in the way of safeguards and investor protections, overseas investors especially can suffer.
There is also a risk factor inherent in your age and your career stage. If you are early to mid-career and your portfolio suffers losses you have the time and the means to recover. If you are close to retirement or retired, your future earning power is limited; the normal volatility of stocks can pose a serious threat. Burton Malkiel makes the point that there is a difference between your attitude toward risk and your capacity for risk. Generally speaking, your capacity for risk is inversely proportional to your age.
We have all heard “no risk—no reward”. So in our minds the two are connected. That certainly is the conventional wisdom in the investing world. It turns out that the conventional wisdom is correct. Risk and return are clearly related. As Malkiel says, “… investment rewards can be increased only by the assumption of greater risk, no lesson is more important in investment management. This fundamental law of finance is supported by centuries of historical data.” (p 330-331) Malkiel cites the “most thorough study on risk and return” conducted by Ibbotson and Associates. It compares returns and standard deviation for several asset classes over the period 1926 to 2005. It shows that both the expected return and the standard deviation for stocks are much higher than those for corporate bonds, which are in turn higher than the measures for government bonds. The lowest return, least risk is provided by US Treasury bills. So in keeping with the idea that asset classes determine returns and now risk, one goal will be to develop your investment policy with an ‘appropriate’ mix of asset classes.
Indeed, the idea that the only way to “beat the market” is to assume greater risk is now very central to investing approaches. This is at the heart of Modern Portfolio Theory (MPT) first presented by Harry Markowitz in the 1950’s. MPT also provides a rigorous foundation for using diversification as the primary means to reduce risk. Risk and reward are clearly linked. The only way to increase possible returns is to increase risk. But taking on more risk in no way guarantees higher returns. More risk also means the chance for bigger losses. So if something promises outsize returns, that means it has commensurate risks. Be careful.
Continued in Part 2.