Portfolio Risk Explained – How To Think About Risk and Volatility

In using the term “risk,” different investors and advisors mean different things. There are several different types and definitions of portfolio risk. Some are more useful than others. Here we'll explore how to think about risk and volatility when it comes to investing.

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Portfolio Risk Defined

So I think it's important to qualify and define what exactly we're talking about when we use the term “risk” in relation to portfolios and investing.

In this post I'm going to be talking about systematic risk, which can't be diversified away. I already covered unsystematic risks – like sector risk, single company risk, etc. – and how to diversify them away in a different post here.

Systematic risks refer to market-wide things like inflation, macroeconomic events, environmental crises, black swan events, etc. These cannot be diversified away and are largely unpredictable. Systematic risk can cause permanent loss of capital, which is the phrase I use as the definition of the word “risk” in relation to investing. Specifically, this would be the probability of such a loss.

Bernstein proposes a pretty intuitive thematic formula for risk as being a function of both the magnitude of loss and the duration of that loss. In terms of portfolio performance metrics, think degree of drawdown and how long it takes to recover from it (if it ever does). Closely related to this is the obvious risk of running out of money in retirement, which I would submit should likely be the primary “risk” that the index investor is concerned about.

Recall the Global Financial Crisis (GFC) of 2008, when the S&P 500 dropped more than 50% and then took several years to recover. If you had the bad luck of entering retirement during this period, it may very well have exploded your retirement plans, particularly if were over-exposed to stocks (not the best idea). This is called sequence risk, which I explained in another post. Basically, a bad sequence of returns is especially damaging for the retiree who is withdrawing from the portfolio for expenses and not replenishing those withdrawals. That's a permanent loss of capital.

Thankfully, markets have always recovered from major crashes within a few years (at least in the U.S.; Japan is a different story). Bernstein calls this “shallow risk” in that it is experienced over the (relatively) short term. That doesn't mean it's harmless by any means. Unfortunately, the highly emotional brain of the average investor experiences risk over the short term and has a hard time envisioning the requisite long road ahead that is the entire investing horizon leading up to retirement, for which an intra-year crash isn't a big deal for the young accumulator and should actually be viewed as an opportunity to buy investments on sale.

As I've said countless times elsewhere, investors tend to severely overestimate their tolerance for risk, only realizing it when they panic sell during a crash and then completely miss the recovery because they're afraid to get back in. That investor has now locked in a permanent loss of capital by selling and then the opportunity cost of foregone recovery gains is the insult added to the injury.

Bernstein refers to unrecoverable permanent loss of capital as “deep risk,” resulting from things like military entanglements, governmental confiscation, and runaway inflation, which unfortunately are not trivial concerns in many parts of the world, and while unlikely in the U.S., are not outside the realm of possibility.

Consider German bondholders, for example, who held pieces of paper that were nearly worthless after seeing their value drop over 90% following World War II, while stockholders, who also saw a decrease in value of over 90%, recovered within a decade. Other developed nations like Japan, Belgium, Finland, France, and Italy saw similar situations in which bondholders suffered permanent loss of capital.

All these examples of losses contribute significantly to the possibility of running out of money in retirement, or not accumulating enough to fund it in the first place. As always, they also illustrate the importance of a well-diversified portfolio.

Volatility vs. Risk

If you've read any of my other posts, you'll notice I always say “volatility and risk” when talking about portfolio performance. Many investors – and even advisors – tend to erroneously and cavalierly interchange these two terms, but they are not the same thing. Volatility is typically measured by standard deviation, the square root of the variance of investment returns. Variance just means discrepancy around the mean value. It's a measure of the price movement of a security or portfolio.

The market's perception of a security's value drives its volatility, but high volatility per se does not mean high returns. Look at commodities, which are extremely volatile yet have a real expected return of about zero. Just because an asset gyrates up and down wildly does not mean it's a good long-term investment.

Volatility matters for short-term traders. They aim to predict and profit from price swings. But if you've stuck around here long enough, hopefully I've convinced you not to be one of them. For the long term buy-and-hold investor, volatility per se should ideally be less of a concern. I say “ideally” because investors are human and therefore not perfectly rational. More on that later.

It should be intuitive that volatility doesn't tell us much about whether or not we'll have enough money at retirement. We can also demonstrate the inequivalence of volatility and risk by showing that combining two very volatile assets – stocks and long treasury bonds – makes for a portfolio less risky than either asset in isolation, which I illustrated here. To get to that retirement number, we're probably going to need some risky assets like stocks, at least early on, as, generally speaking, risk and return are inextricably linked.

In point of fact, we should want greater volatility on the upside, as that's where returns come from, and a small handful of days of massive gains are usually responsible for the market's performance over an entire year. Investors think they fear volatility, but they only complain or worry about it when it happens on the downside. I'd imagine you'd be hard-pressed to find an investor who, after seeing a highly volatile day of a 10% gain, would exclaim “my portfolio is too risky!”

In fairness, when casually comparing securities or asset types, volatility may be the best proxy we've got for talking about their relative riskiness, so I understand why people conflate the two terms. I also concede that volatility is itself a risk due to what we call “decay,” but that's a story for another time. On average, stocks are much more volatile than bonds. We would also say stocks are riskier than bonds. That risk of uncertainty is a wide dispersion of possible outcomes.

But in terms of accumulating enough money to retire, we can say the bond portfolio would technically be “riskier” in that we wouldn't expect its returns to be high enough to provide the growth we need. Moreover, over the long term, inflation would be more damaging to a bond portfolio than to an equities portfolio. In other words, what may look riskier in the short term may be less risky over the long term. Confusing, right?

Once again, we can easily conclude that a well-diversified portfolio is the way to go when nearing retirement.

Risk Tolerance

Now let's talk about risk tolerance.

A successful investing strategy requires that the investor is able to stick to it. Modern Portfolio Theory assumes all investors behave rationally and unemotionally. We know this isn't the case.

The investor is usually the cause of the failure of their investment plan, not the financial markets. As you might imagine, plans are typically abandoned during crashes or extreme bull markets. One of the mistakes most often made is the overestimation of one's tolerance for risk. Risk tolerance can be defined as the point at which price volatility (swinging movement) or drawdown (drops in value; loss of capital) causes you to change your behavior. Obviously, for a young investor with no experience, this point can be hard to assess.

In this sense, risk tolerance becomes highly personal, subjective, and hard to quantify. This is the point at which one stresses out and makes irrational decisions, further derailing their plan. Tolerance for risk is largely borne of one's personality, beliefs, and investing experience. Some are naturally risk-averse, and others are naturally risk-seeking. Unfortunately, the latter group tends to seek excitement in their portfolios, but financial markets are no place for thrills. The best, most successful strategies are usually quite boring, and for good reason. As Bernstein says, if you want some excitement in your life, go skydiving.

For a hypothetical, simplistic, reductive example of risk tolerance, suppose an investor determines that they cannot emotionally withstand seeing a loss greater than 20% or volatility, measured by standard deviation, greater than 10%. We might say this investor has a low or “conservative” tolerance for risk and estimate that this means they should be in nothing more aggressive than a 40/60 stocks/bonds portfolio, otherwise they may abandon their strategy at the worst possible time. This of course also assumes that the expected return of such an asset allocation would still allow them to meet their financial liability and achieve their goals. Note that the numbers I used here are made up, and the future may not look the same as the past.

An entire post could be dedicated to behavioral finance and risk tolerance alone. It is highly personal and involves complex psychology from usually-irrational human behavior that we can't reliably predict ourselves. In investing, unfortunately, the stomach is usually more powerful than the mind. I've got a separate post on biases that investors often succumb to, usually unknowingly.

William Bernstein suggested that an investor can evaluate their risk tolerance based on how they reacted to the Global Financial Crisis of 2008:

• Sold: low risk tolerance
• Held steady: moderate risk tolerance
• Bought more: high risk tolerance
• Bought more and hoped for further declines: very high risk tolerance

Pick a risk level that lets you sleep at night. Again, most investors severely overestimate their tolerance for risk, only realizing their true risk tolerance during a market crash when their portfolio value tanks. It's also been theorized that investors may be embarrassed to admit to their advisor – or to themselves – that they have a low tolerance for risk. Don't be.

It is imperative to have realistic expectations of both the markets and of one's own behaviors. The behavioral aspect of investing is unfortunately very real and can have significant consequences. Emotional responses to one's environment – in this case a financial environment – are hardwired in the human brain. Are you going to lose sleep and panic sell if your portfolio value drops by 57% like it did for an S&P 500 index investor in 2008?

Also keep in mind that stocks tend to do worse when you are doing worse. That is, your human capital tends to suffer at the same times that your investment capital suffers, so be sure to have an emergency fund established to avoid being forced to sell low and lock in losses just because you need the income during an economic downturn.

Lastly, acknowledge and account for cognitive biases such as loss aversion, the principle that humans are generally more sensitive to losses than to gains, suggesting we tend to do more to avoid losses than to acquire gains.

Vanguard has a useful page showing historical returns and risk metrics for different asset allocation models that may help your decision process. Once again, remember that same performance seen on that page may not occur in the future.

Vanguard also has a neat questionnaire tool that can be used as a starting point. The questionnaire incorporates time horizon and risk tolerance to help you figure out an asset allocation that may be appropriate for you. You can check it out here. While it may be a useful exercise, it’s still only one piece of the puzzle and doesn’t factor in things like current mood, current market sentiment, external influence etc. Be mindful of these things and try to be as objective as possible. If you answer these questions during a prosperous bull market, for example, your attitude will almost certainly be overly optimistic and your answers will indicate a maximum risk tolerance higher than your true level. It doesn’t make much sense to try to assess one’s maximum risk tolerance during ideal market conditions. It is probably best to take these questionnaires after a market decline.

Note too that deviating from one's strategy does not have to come in the form of selling during a crash. This can also mean not investing new money due to being scared of the markets after a crash, or delaying investments because you think the market looks expensive. Over the long term, all these behaviors increase risk by decreasing total return and reliability of outcome.

Because of all this, the older I get, the more I've come to realize the simple fact that most investors would likely be better off with a well-diversified portfolio that aims to reduce volatility and risk, such as the All Weather Portfolio, not one that seeks to simply maximize expected returns (e.g. “100% stocks until age 40!”). If the investor with an aggressive portfolio panic sells during a crash and misses out on the recovery, they almost certainly would have been better off with a more conservative portfolio the entire time from the start. This is vaguely reminiscent of the analogy of the tortoise and the hare. A suboptimal strategy you can stick with is better than an optimal strategy that is abandoned in times of crisis.

Larry Swedroe notes: “The discipline to stay the course with an asset allocation is in all likelihood the greatest determinant of returns in the long run, more so than asset allocation itself.”

Trust that you will go through a period of market turmoil where your risk tolerance and subsequent adherence to your investment plan and asset allocation will be tested.

Risk Capacity and the Need for Risk

Of course, risk tolerance isn't the only consideration when developing an investing strategy. One must also consider their risk capacity and need for risk.

Risk capacity refers to the investor's ability to take on risk. Specifically, we can think of risk capacity as the amount of risk the investor is able to take on before it interferes with the viability of achieving the financial objective. It is determined by one's time horizon, portfolio value, and availability of other assets and income.

As you might imagine, this capacity is inherently inversely correlated with age. In terms of actual investments, we can even say that risk capacity is generally positively correlated with one's allocation to stocks, as I discussed in my post on asset allocation. The young investor with a stable job, healthy emergency fund, and a time horizon of 40 years has the ability to go 100% stocks because the portfolio can sustain a crash – even multiple crashes – and still achieve the financial objective because it has decades to recover and future capital inflows to support it. That is, the young accumulator has a large capacity for risk. Granted, this investor may very well have a low emotional tolerance for risk, as described above, that may prevent her from using 100% stocks, even though she has the capacity for it.

But at a certain point, a low tolerance for risk must be squared with the fundamental need for risk. Remember, broadly speaking, risk and return are inextricably linked. Investing 100% in T-bills, the risk-free asset, is unlikely to allow the investor to save enough for retirement, because the portfolio's returns will almost certainly barely beat inflation over the long term. So the investor must come to terms with the fact that, for a given time horizon, she needs to assume a certain amount of risk in order to generate the return necessary to meet her financial objective. If she is emotionally unwilling to do so, that time horizon must necessarily increase to allow for more growth, her income and savings rate must drastically increase, and/or her expenses must drastically decrease.

Of course, the opposite is true of the retiree, who may very well have a high psychological tolerance for risk but who no longer has the need for it. This is a great situation to be in. If markets have been kind and the investor approaching retirement has accumulated enough investment capital to fund their expenses in retirement, they no longer need to take on risk. It should be obvious that it is illogical to take on more risk than is necessary to achieve the financial goal. Again, once you've won the game, stop playing.

The retiree also no longer has the capacity for risk unless they have overshot their savings goal (or have some extra money from a pension and/or Social Security), as their human capital has dried up and they are now withdrawing from a portfolio – in good times and bad – that receives no new deposits to replenish it. That is, the retiree simply cannot afford to take on risk due to the possibility of severe market downturns derailing the retirement withdrawal plan (i.e. sequence risk). The same is true for an investor with a short time horizon for a known liability, such as a house downpayment or a college tuition.

If the investor receives a sudden unexpected windfall like an inheritance, starts receiving Social Security, and/or takes on a part-time job in their free time, their risk capacity has now increased. My father is a decent example of this. He recently entered retirement with a healthy amount accumulated in his IRA and receives both a pension and Social Security, so while he has the tolerance and capacity for risk, he no longer has the need for it, and is thus invested in a relatively conservative mix of assets to simply keep up with inflation.

As you can see, the need for liquidity is inversely correlated with risk capacity. This is why the general rule of thumb is not to invest in stocks with money you'll need in the next 5 years.

Many find themselves somewhere in the middle. They may have a moderate risk tolerance, a necessarily low risk capacity as they near retirement, but also still a need to take on risk simply because they haven't saved enough or because the markets have not been kind over their investing horizon up to that point. This means they must delay retirement, cut expenses, and/or take on more risk than might otherwise be sensible in order to attempt to generate greater returns. Those first two deliver a predictable, guaranteed return and should be preferable; the third one opens the door to uncertainty and a wider dispersion of possible outcomes.

A Note on Advisors, Financial Planning, and Risk

Unfortunately, the traditional financial planning paradigm tends to conflate risk tolerance, requirement, and capacity, and clients are typically worse off for it.

Just because a client in retirement has a psychological appetite – and even capacity – for risk does not mean their bowl should be filled to the brim with it, as they may no longer have the need. Likewise, advisors should not blindly over-risk young clients who may very well not – and likely don't – have the tolerance for an all-equities portfolio.

The challenge, of course, is educating clients on these concepts, as their perception of risk is driven almost entirely by recency and their investing experience. When things are going well (think steady bull market, e.g. 2010-2019), investors tend to [understandably] view markets with rose-tinted glasses and overestimate their tolerance for risk simply because they underestimate the probability of bad outcomes. We call this overconfidence, and it can be very dangerous.

Contrariwise, investors who have recently experienced an appreciable degree of market turmoil (think 2008 crash) tend to mentally anchor to those events, extrapolate their impact and overestimate their probability, and shy away from risk out of fear, for better or for worse. They also tend to make quick, irrational, emotionally-charged financial decisions that are almost always more harmful than helpful. Recall the principle of loss aversion, which means we're more sensitive to losses than to gains.

One of the primary jobs of advisors, and admittedly a tough one, is to manage and contextualize clients' evolving perceptions of risk in the face of volatile markets.

Measuring Portfolio Risk – Some Metrics

Here we'll briefly cover some ways to measure portfolio risk.

I'm not going to get too in the weeds here because I've got a separate post on some risk metrics, but here are a few based on things we've discussed already:

• Standard deviation, abbreviated st. dev. – measure of volatility; written as a percentage. It's the square root of the variance of return. Volatility is the erratic up-and-down price movement of an asset. For example, the historical volatility of U.S. stocks has been about 15%.
• Max drawdown – as the name suggests, measures the maximum drop in value of an asset or portfolio sustained over a given time period. For example, U.S. stocks dropped about 57% in the 2008 crash.
• Value at Risk, abbreviated VaR – measures the probability of a defined loss over a given time period. Usually uses a 95% confidence interval.
• Sharpe ratio – the ratio of return to volatility. Measures what's called “risk-adjusted return,” if one wants to use volatility as a proxy for risk, which I said is probably not the best approach.
• Sortino ratio – same as Sharpe but only uses downside variability.
• Calmar ratio – ratio of return to max drawdown. Another measure of risk-adjusted return.
• Ulcer Index – measures the magnitude and duration of drawdowns.
• Ulcer Performance Index (UPI) – ratio of return to Ulcer Index.
• Excess kurtosis – measures tail risk of an investment or a portfolio compared to a Gaussian/Normal distribution. Basically, what's the probability of an extreme outcome?
• Safe withdrawal rate, abbreviated SWR – the estimated rate at which one can begin withdrawing from a portfolio in retirement and then adjust for inflation each year without exhausting the portfolio. It's just an estimate! Allows one to reverse engineer an estimate for how much they need to save for retirement. I delved into the details here.

How To Reduce Portfolio Risk

So what can we do to reduce all this risk of loss of capital? Thankfully, it's pretty simple, and it's the thing I've harped on ad nauseam all over this website. The answer is diversification.

And I don't just mean the stupid rule of thumb of holding “more than 30 stocks to be diversified.” I'm talking about extensively diversifying across:

• Different asset classes – stocks, bonds, etc.
• Different assets within those classes – Google, Amazon, Johnson & Johnson, Tesla, treasury bonds, etc.
• Different cap sizes – small stocks, large stocks, etc.
• Different styles – value stocks and growth stocks.
• Different sectors – technology, financials, industrials, etc.
• Different geographies – stocks and bonds from different developed countries and developing countries around the world.
• Different exposure through time, aka temporal diversification.
• Different, independent sources of systematic portfolio risk, known colloquially as factors.

Again, I delved into the details of how to do all that in a separate post. Conveniently, the above tactics also mitigate portfolio volatility, making things easier on your stomach.

Pick an asset allocation appropriate for your personal time horizon, goals, and risk tolerance. More on that last one in a second. Investing is deferring present consumption for future consumption. We are allocating capital for future liabilities, so the strategy we use to get there must be expected to generate a return that is able to fund that future consumption. This is the primary “risk” I alluded to earlier: running out of money in retirement. As Bernstein says, the goal is not to get rich, but rather to avoid dying poor.

The rational young accumulator should likely be mostly in stocks. But again, it cannot be overstated that investors tend to overestimate their tolerance for risk, so adjust accordingly. Diversification is the closest thing to a free lunch in investing, but you will still lose money on occasion. Ignore the short-term noise and stay the course.

The retiree who has already accumulated the savings that will adequately cover their estimated expenses in retirement should remove the portfolio's risk entirely by taking up a near-riskless TIPS ladder or inflation-adjusted annuity. Once you win the game, stop playing. Of course, most will not reach that point, and will still rely on modest returns in retirement. I delved into retirement withdrawal rates here.

Lastly, I explained how one can mitigate sequence risk by adopting a variable retirement spending strategy in a separate post here.

Conclusion

I would encourage you to think about risk in a more nuanced way when evaluating your investing strategy. It is more than just the standard deviation of returns (measure of volatility). Invest according to your personal time horizon, risk profile, and objectives, but remember that past performance does not indicate future performance. There may also be a crash in the future that is worse and longer-lasting than any we've seen historically.

Remember, risk is experienced emotionally over the short term through volatility and drawdowns. Try your hardest to adopt a long-term mindset, ignore the headlines and the short-term noise, and stay the course. In terms of the relationship between riskiness and expected returns, a suboptimal strategy you can stick with is better than an optimal strategy that is abandoned when there's blood in the streets. Selling during a crash locks in a permanent loss of capital.

Understanding one's tolerance, capacity, and need for risk is the crucial foundation of any retirement plan and investing strategy. Any advisor worth their salt should likely spend just as much, if not more time doing a risk analysis to assess these as they would talking about investment products. DIY investors should objectively take stock of these components of their own risk profile and make sure their investing strategy is aligned.

Investing is deferring present consumption to fund future consumption. Your primary risk is running out of money in retirement. In order to avoid that, you must necessarily take on some level of investment risk, so you must also necessarily have some capacity and tolerance for that risk. If you don't have both, you have a tough road ahead of you in trying to avoid dying poor.

How do you think about risk? Let me know in the comments.

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Disclaimer:  While I love diving into investing-related data and playing around with backtests, this is not financial advice, investing advice, or tax advice. The information on this website is for informational, educational, and entertainment purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a research report. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. I always attempt to ensure the accuracy of information presented but that accuracy cannot be guaranteed. Do your own due diligence. I mention M1 Finance a lot around here. M1 does not provide investment advice, and this is not an offer or solicitation of an offer, or advice to buy or sell any security, and you are encouraged to consult your personal investment, legal, and tax advisors. Hypothetical examples used, such as historical backtests, do not reflect any specific investments, are for illustrative purposes only, and should not be considered an offer to buy or sell any products. All investing involves risk, including the risk of losing the money you invest. Past performance does not guarantee future results. Opinions are my own and do not represent those of other parties mentioned. Read my lengthier disclaimer here.