Worried about another sell-off? Time to reframe how you view risk

Risk and investing are two sides of the same coin. Conventional wisdom teaches us that greater risk can lead to greater returns, but the concept of risk itself remains poorly understood by many investors.

The foundation of modern portfolio theory (MPT) relies on the standard deviation of returns as a primary measure of risk. In simple terms, the more volatile the returns, the higher the standard deviation, which theoretically translates to higher risk.

Professional investors use this metric to gauge the range of potential future outcomes and their associated probabilities. Yet, despite its prevalence in financial models, the standard deviation of returns is often misunderstood or overlooked by investors.

In his book The Psychology of Money, Morgan Housel offered the perspective that volatility should be viewed as a “fee” rather than a “fine”. Housel argues that the uncertainty and fluctuation in prices are simply the costs that investors pay for the opportunity to earn returns.

But in the same passage, Housel writes: “Few investors have the disposition to say I’m actually fine if I lose 20 per cent of my money”.

That is not a description of price volatility, that is a description of the risk of a loss. The key difference is that the MPT definition of volatility also considers the “risk” of price rises.

On purpose or not, Housel has highlighted that most people equate volatility with the risk of loss, not the standard deviation of returns. And by people, I also include investment professionals.

Warren Buffett once succinctly captured the essence of how most people understand investment risk: “The first rule of investment is don’t lose [money]. And the second rule of an investment is don’t forget the first rule.”

The relationship between the standard deviation of returns and actual losses has been hotly debated. It has come more to the fore in recent times amid the growing allocations to private markets such as private credit.

Private assets, unlike public markets, are appraised less frequently, which can result in a misleadingly low standard deviation. Therefore, volatility isn’t a reliable indicator of potential losses. Many institutional investors have had to write some of these assets down to zero.

The infrequent pricing of private assets can obscure the real risks involved, as market price discovery is limited. When these risks materialise, they often capture headlines because, as humans, we are hardwired to react more strongly to losses than to gains – a concept at the heart of prospect theory.

But that is not the only cognitive bias investors have to deal with. While the risk of loss can be understood, the uncertainty of returns – high standard deviation in both directions – presents a more complex challenge.

Studies consistently show that humans struggle with decision-making in the face of uncertainty, often falling prey to biases like the recency effect. For instance, early August’s sharemarket decline might disproportionately influence investors’ short-term decisions, despite the long-term outlook.

This cognitive bias is also known as “availability”. This occurs when people estimate the likelihood of an event based on how easily they can recall similar occurrences. Recent negative experiences tend to dominate our memories, leading us to overestimate the probability of future losses – even when market downturns create buying opportunities.

Markets today move at breakneck speed, making it difficult to accurately assess risk in real-time. The key for investors is to filter out the noise of short-term market commentary and remain focused on long-term objectives.

As Housel states, “Stick around long enough for investing gains to work in your favour.” At pains to point out there is no guarantee, the emphasis here is “long enough”.

Successful investors weather short-term standard deviation of returns by adhering to proven investment principles. For portfolios, this may mean enhanced diversification. These strategies have historically provided portfolios with the resilience needed to endure market turbulence.

But key is understanding the timeframe. That could determine whether you concern yourself more with the standard deviation of returns, or whether the risks you consider are the loss of capital, which is likely over the shorter term. Not considering either is a risk.

Another classic Buffett-ism that should be at the forefront of investor’s minds is: “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”

This column was first published on the Australian Financial Review.