Risky Business: What Investment Risk Really Means

In his recent letter to investors, Oaktree’s Howard Marks makes what we believe to be a profound observation about how risk is treated in investing. Many times, investment commentary will define investment risk as volatility. However, in “Risk Revisited Again,” Marks makes this keen observation:

“I don’t think most investors fear volatility…What they fear is the possibility of permanent loss.”

At Balentine, we have long defined risk as the permanent impairment of capital, and it has been the foremost directive of our investment process. Indeed, we have a dedicated Director of Risk Management, and our entire building blocks approach is built upon the this foundation. The purpose of building blocks is to group up asset classes according to risk characteristics. One building block in particular—“Liquid Reserves”—is designed specifically to alleviate the potential for permanent impairment of capital by treating cash as an asset class. Director of Risk Management and Implementation David Damiani championed this idea in “The Case for Cash,” his 2012 article for the CFA Institute:

“The goal of the cash reserve is to eliminate the uncertainty around the source of the funds over the short- to intermediate-term, thereby “immunizing” distribution requirements. Although it is true that holding cash during a rising market dampens potential positive returns, this is merely an opportunity cost, not a realized loss. But liquidation of assets during a falling market can exacerbate negative returns and create a realized investment loss that directly impacts the portfolio’s rate of return.”

However, as Marks rightly points out, there is also the “risk of not taking enough risk,” meaning that a portfolio is not generating enough in returns to sustain an investor’s needs. Sometimes, the unfortunate reality is that not all goals are attainable. While this can be a painful realization, it is important to address and reconcile up front. After all, disappointment comes when there is a gap between expectations and the reality of the situation. Oftentimes, however, goals are attainable, and an important part of our job is to help clients construct portfolios that meet their goals in the most suitable way for their situation.

As our Investment Strategy Team detailed in this year’s Capital Markets Forecast, there are several ways of attaining these goals. Though the end is the same, each various journey to that destination comes with its own risks and rewards. Some factors to consider include time horizon, spending requirements, portfolio contributions and behaviors. From the outset of each relationship, we seek to understand the unique needs and situations. By getting to know our clients on a deeply personal level, we are able to engineer their paths forward in the most appropriate manner for their goals and risk tolerances and define success solely on their terms.

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