The Great Investment Heresy: Risk Doesn’t Matter

Some old-school types will not finish reading this article. They’ll throw it down in disgust, declaring it a piece of heresy for questioning the theory they’ve based their life’s work on.

On the other hand, a different but still small group of retirement fiduciaries will read this and say, “Been there, done that.”

Finally, the bulk of today’s professionals and 401(k) plan sponsors alike will want to know how they can tweak their current models and menus to better integrate some of the features laid out here.

From both a conceptual and a mathematical standpoint, fiduciaries can no longer use volatility to measure risk.

If you’re one of the few who continue to knowingly advocate the use of volatility to measure risk, now is the time to read this. If that doesn’t convince, then now’s your cue to toss the device you’re reading this on … unless of course you’re tempted to see how the rest of the world operates.

Despite the common-sense argument against using volatility and the growing consensus to not use volatility, it’s almost impossible to avoid using it. It’s built into the fabric of nearly every investment presentation, nearly every portfolio optimizer, heck, almost any asset allocation tool. Asset allocation itself would fail if we removed volatility as a measure of risk from the equation.

And therein lies the solution to the problem. Most of these asset allocators start with the premise that the investment markets derive the action.

This is exactly the opposite from the way a new breed of investment advisors are approaching things (see “Has the 401k Fiduciary Unknowingly Put Employees in Peril?FiduciaryNews.com, June 10).

Now, before you get on your haunches, I know there are more than a few grizzled veterans who remember the way things were done before Modern Portfolio Theory spread like a virus in the 1980s. I have no doubt these folks will recognize some of what is being said here as “the way we used to do things.”

It all begins with The Great Heresy: Risk Doesn’t Matter.

That’s right. Risk doesn’t matter. Go ahead. Say it out loud. “Risk doesn’t matter.”

Still not convinced? How about this example (based on a favorite trick question of mine from the days I taught young trust officers)? For those who don’t know, a trust officer is the ultimate fiduciary. In fact, everything we know about fiduciary duty comes from centuries of trust law.

So, let’s say you’re the trustee of a 25-year-old of modest means and no great inheritance prospects. You’re broker counterpart, in the bank’s brokerage division, is competing with you for this client, knocks on your door holding in his precious hands a freshly completed risk questionnaire.

“He’s entirely risk averse,” says the broker. “I’m going to recommend on of my favorite bond funds. Based on his risk assessment they’re perfectly suitable. He’ll pick me because I did the risk questionnaire before you did,” declares your snotty coworker as he thumbs his nose at you while leaving your office.

A week later the same coworker saunters by his office, his tail between his legs, as you speak to your new 25-year-old client. Yes, you won the business from the bratty broker. How did you do it?

Because, as a fiduciary, you weren’t interested in the merely suitable, you wanted only what was in the best interests of your client.

The piece of business at hand was an IRA. The young man was only 25. The earliest he could tap into the IRA wasn’t until another 35 years. Given his existing account size, annual contribution rate and projected retirement income need, you determined this young investor needed to get an annual return of 6.95%.

You explained, over the long haul – and with a 35-year time horizon, he’s certainly in it for the long haul – stocks have far exceeded that return. Bonds are more likely to guarantee you’ll fall short of your goal. That’s not a good thing.

For a moment, you weren’t sure if you got the account as the then-prospect asks, “But what about the risk tolerance questionnaire I took?”

You sit back and smile. “The person who took that questionnaire is you as a 25-year-old. As trustee of your IRA, I’m not working for the you of today, I’m working for the you of tomorrow (specifically, 35 years of tomorrows).”

If focusing on the investor's return requirement first makes perfect sense to you (and it should), rejoice and repeat after me. “Risk doesn’t matter.”

And be prepared to join with me and many others as things will no doubt get toasty at the burning stake.

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