The “Top 5 Things An Investor Should Know” - #3

It’s been a while since I focused on “The top 5”…but given the past two weeks of declines in the markets, I think it’s time to trot out number three (#3). If you haven’t read #1 and #2 or just want a refresher, you can read them here (#1) and here (#2). I also touched on the following topic briefly in a previous post here.

So here we go…The Top 5 Things An Investor Should Know - #3

#3 - Risk is Underestimated

Do you really know how much risk you can handle?

If you’ve ever gone into an investment broker’s office or opened a broker account of any sort, you’ve probably filled out a “risk tolerance” questionnaire. This is a tool to help the investment broker figure out how much risk you are willing to take on as part of your investment strategy (and to cover his tail should an investment he put you in not pan out…“your questionnaire said you can accept high risk!”). As an example, a question might ask:

You just invested $20,000 and the market falls the following week. During the fall, you lost 50% of your investment. What would you do?

A) Take your money out
B) Reallocate your money to other investments
C) Do nothing and hope it recovers
D) Keep contributing to the investment regularly.

Depending on how you answer gives the broker an idea of your tolerance for risk and risky investments.

Now, this is all nice and good, but the reality of losing 50% of your new investment (for example) is a lot more stressful than when you’re sitting in a nice peaceful office filling out something on a clipboard. If you were to fill out the survey during a market decline, I’d guarantee your answers would be different than if you filled it out during a period when the market is averaging a 15% return. All the surveys go out the door when reality hits. That’s a big problem. Your risk tolerance really can’t be identified by a survey.

Statistical Flaws

The second problem we face is that the underlying statistical approach to risk (and to which the approach of our financial system is based on) is flawed.

I’ll try and make this as simple as possible…

From your high school mathematics days (or maybe college statistics class) do you recognize the chart below? It’s the “Bell shaped curve” or “normal distribution” diagram. From it, we can infer that given enough observations and time, such observations will form the following line (plain English: over a certain time period, take all observations, graph them, and you should get this curve).

As this graph shows, the number of standard deviations (σ) you get away from the center (mean), the less chance of an “outside event” happening.

For example, take the average height of men in the U.S. (see my lame bell curve illustration below). Most men fall within being 5’8” to 6’0” tall. That’s within standard deviation of 1 on either side of the mean. Thus 68.26% of men fall within that height range.

Going out another standard deviation of +/-2, you have men that fall within 5’6” and 6’2”. Thus, 95.44% of men are accounted for.

By the time you get to a standard deviation of +/- 3, you can account for 99.74% of explainable observations and thus have a 0.26% chance of an even further “outside event” occurring.

So someone that is 7’0” tall has a very small percentage chance of occurring.

Stick with me, this is going somewhere…now let’s apply it to finance and investing.

Let’s look at the historical daily percentage change of the Dow Jones Industrial Average ("The Dow" – a stock index comprised of some of the 30 largest U.S. companies) for the last 90+ years.

My note: The following information (and height summaries above) has been summarized and represented from an excellent book called The (mis)Behavior of Markets by Benoit Mandelbrot (a great read for any of you mathematics nerds out there with a lot of time on your hands - ha!).

Based on the theory of a normal distribution curve (like the graph), we should expect that a swing of more than 3.4% (positive + or negative -) in the market should occur approximately 58 times. In fact, such a swing in the Dow occurred more than 1,000 times since 1915!

A swing of 4.5% or greater should occur 6 times. We’ve had over 370!

Swings of more than 7% should come once every 300,000 years (a probability of about one in 50 billion). 48 happened in the twentieth century alone!

For fun, the 29.2% drop that occurred on “Black Friday” October 19, 1987 was something like a 22 standard deviation event and had a probability of less than one in 10⁵⁰ – odds so small that it is without meaning. It’s a number outside the very scale of nature.

Either we are having a century of really bad luck, or our statistical models used for understanding risk are flawed.

Components of Risk

Finally, there are multiple components to investment risk (see chart below for some examples).

Let’s spotlight a big one that is relevant from this past week: “Political” risk.

As you are most likely aware, Standard & Poor’s (S&P) credit ratings agency downgraded the U.S. debt on Friday, August 5th and all Hades broke loose in the markets this past week. Here’s a snippet from Bloomberg's "U.S. Loses AAA Credit Rating as S&P Slams Debt, Politics —"

Standard & Poors downgraded the U.S.’s AAA credit rating for the first time, slamming the nation’s political process and criticizing lawmakers for failing to cut spending enough to reduce record budget deficits.

S&P lowered the U.S. one level to AA+ while keeping the outlook at “negative” as it becomes less confident Congress will end Bush-era tax cuts or tackle entitlements. The rating may be cut to AA within two years if spending reductions are lower than agreed to, interest rates rise or “new fiscal pressures” result in higher general government debt, the New York-based firm said yesterday...

“More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating,” S&P said.

S&P put the U.S. government on notice on April 18 that it risked losing the AAA rating it had since 1941 unless lawmakers agreed on a plan by 2013 to reduce budget deficits and the national debt. It indicated last month that anything less than $4 trillion in cuts would jeopardize the rating.

Did you see that? “…the effectiveness, stability, and predictability of American policymaking and political institutions have weakened…” This is political risk - uncertainty of what our government officials might do.

Don’t let the word “credit” trick you here…to be clear, S&P is downgrading our credit based on uncertainty of our political resolve to handle our debt (political risk) not our ability to pay our debts (credit risk). The Treasury department repeatedly noted in the days leading up to the debt ceiling deadline that bond holders would be paid first so that the U.S. would not default on its debt obligations. Thus, credit risk was taken off the table. What wasn’t taken off the table was political risk.

Side bar: In my opinion, the downgrade was a good slap in the face wake-up call for our federal government. The elephant in the room finally was called out. Our federal government is fiscally driving the country towards the drop-off of a very large cliff…and someone finally shouted “look out!” It’s unfortunate that there is now much finger pointing between political parties as to who’s to blame for the downgrade instead of banding together to fix the problem. The political jockeying for position is a stench in my nostrils. But I digress…

We now have tangible examples of what political risk can do here…the charts below (click to enlarge) are of the largest one day percentage drops in the S&P 500 index and Dow Jones Industrial Average. Thought you’d be interested to see where some of the one day drops this last week measured up…

FYI – the 8/8/11 date noted is the first day of trading after the S&P downgrade.

Here’s the bottom line: “Unlikely events in the financial markets are far more likely than most investors believe.”

-Nassim “Nicholas” Taleb, author The Black Swan (Not the movie, but the financial book).

So, I’m sure your next question is something like the following:

“So, how do I eliminate risk?”

That, my friends will have to come in another post…