It might be a good moment to talk about risk.
I’ve written in the past that the problem with discussions of investment risk is that they usually mix up volatility and risk, which are, or at least should be, two different things.
Asset allocation structures and theories going back to the invention of Modern Portfolio Theory by Harry Markowitz in 1952 always produce measurements of risk that are actually measurements of volatility; asset allocations are designed to achieve the maximum return from a given level of risk/volatility.
And of course for professional money managers, volatility IS risk, because they get judged every month, or quarter, and like a journalist who is only as good as his last column, a money manager is only as good as her last quarter.
But for a proper definition of risk, turn to Warren Buffett. Two quotes: “in order to survive, you must first survive”, and “rule number one is ‘don’t lose money’; rule number two is remember rule number one”.
What does he mean? He means that risk is about loss, and more specifically total loss.
Consider this thought experiment proposed by Nassim Nicholas Taleb, author of the “Black Swan”, in a recent article.
One hundred people go into a casino to gamble. Now assume that gambler number 28 goes bust; none of the others is affected. You can safely calculate that, from this sample, 1% of the gamblers goes bust. If you keep doing the same experiment, an average of 1% will go bust.
Now, one person goes into the casino one hundred days in a row. Using the same 1% probability analysis, he will go bust on day 28. Will there be a day 29 for him? No. There is no game anymore.
For him that 1% probability turned into 100% because he kept doing it for 100 days.
Unless you need your cash within 12 months, or have to report to a flint-eyed spouse every quarter, an individual investor’s risk is not about volatility but permanent loss.
In my view this means you pay no attention to the financial advice industry on the question of asset allocation, unless the adviser does NOT ask you about your “risk tolerance”. In the world of “Rule No.1” there can be no tolerance for loss.
Taleb’s version of Rule No.1 is: “never cross a river if it is on average four feet deep.”
“I effectively organized all my life around the point that sequence matters and the presence of ruin does not allow cost-benefit analyses.”
“Risk and ruin,” he concludes, “are different things”. I agree.
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