Risk by any other name is loss

Nobody likes to lose money. That's why the investment industry shies away from the word "loss." It prefers euphemisms such as "risk" or, vaguer still, "drawdown."

Fred Kirby believes in calling a spade a spade. In an extensive article titled "Investment Risk from the Client's Perspective," published in the prestigious U.S.-based Journal of Financial Planning, the Canadian fee-only financial planner tackles the forbidden topic of losses head-on.

For ordinary investors, risk is a benign word for the possibility of losing money, says Kirby, a certified financial planner based in Armstrong, B.C. "In our culture, risk-takers are often rewarded, even admired. But notice how the meaning changes when 'loss' is substituted for 'risk.' " Suddenly, Kirby says, a "risk-taker" is transformed into the less glamorous-sounding "loss-taker" -- or worse, "loser."

The financial industry loves to talk about the "returns" accruing from the upside of risk. But when forced to admit losses suffered by its customers, it often selectively presents its data. In one of the worst bear markets in history -- from May, 1927 to May, 1932 -- investors in a balanced portfolio suffered an "annualized loss" of 11.7%. If you think that's not too bad, consider how you'd feel if the same situation were described as a 46.3% "total loss" in those same five years.

In similar fashion, mutual fund companies often summarize performance by specifying the best and worst periods in one month, three months and 12 months. But what happens if losses extend for several years?

Investors use financial advisors to help them create diversified portfolios designed to optimize risk and returns. The idea is to "stay the course" by remaining invested over the long haul.

The problem, as Kirby notes, is that the theoretical questionnaires advisors use with clients can backfire. Investors actually have two different investment time horizons: a stated one and an actual one. When clients finally confront real losses, they may panic and abandon carefully constructed portfolios at the worst possible time.

This results in the type of "buy-high, sell-low" behaviour we saw between 1999 and 2002. Many investors jumped on the tech-stock bandwagon at historic highs, then, when the Nasdaq exchange plummeted from 5,000 to 1,200, jumped off again at the worst possible time. Even sophisticated fund managers can succumb to the same affliction of "myopic investing," Kirby says.

The illustration shows the behaviour of a balanced portfolio that peaked at $104,000 in the most recent bear market, from 2001 to 2003. It shows both the extent (or magnitude) of the losses -- or "drawdown" -- as well as the duration, or how long the losses dragged on.

It took about a year to suffer a peak-to-trough loss of $15,000, then another year to get back to even and start making money again. Clearly if you panicked and sold when the portfolio was only $88,000, you would turn a theoretical loss into an absolute loss.

The traditional cure for this is asset allocation -- buffering stock market exposure with less volatile fixed-income investments, typically bonds. The classic pension fund has 60% equities and 40% bonds, a mix mimicked in the popular "balanced funds" sold to retail investors.

Returns from such balanced portfolios will be lower than portfolios holding 100% stocks. But on the upside, when the inevitable market "correction" occurs, bonds will reduce the severity of the loss enough that the investor won't be tempted to sell everything at the worst possible time. That's why Richard Ferri, in his book All About Asset Allocation, recommends setting your portfolio slightly below your true risk tolerance.

Where Kirby's article breaks new ground is in his analysis of not just the magnitude of bear-market losses, but also their duration. As he says, "the duration of a loss can be just as significant to an investor's actions as a dollar loss."

Kirby shows how various portfolios of U.S. stocks and mid-term government bonds would have behaved between 1926 and 2003. As you would expect, losses decrease as the bond weighting increases. So the worst decline for a 100% stock portfolio was 86%, while a portfolio with no stocks and 100% bonds lost only 9%.

The time factor also must be considered. "In the emotion-laden world of investing, poor decisions can just as easily result from losing patience as from losing money." Adding bonds to a portfolio reduces the time needed (in months) to recover losses. The surprising finding is they don't buffer the "time" element of losing as effectively as they reduce the sheer magnitude of short-term losses.

For portfolios with less than 50% bond content, the number of months needed to recover losses in the worst bear markets ranged from 74 to 88. Only when bonds reached 60% of a portfolio did they result in a substantial acceleration of the time to recover losses: 46 months for 70% bonds and 26 months for portfolios with 90% bonds. Kirby says if investors can tolerate 39 months (over three years!) of a protracted market decline, they should consider at least a 20% exposure to stocks.

Short-term bear markets that last within a narrow and emotionally tolerable range of less than a year are most common. But 15% of the time, investors can expect wild swings, with the worst case eight times more than normal fluctuations. Kirby found half the worst bear markets lasted nine to 12 months for those with properly balanced portfolios.

But the rare "mama bear" lasted 75 months. How many investors in a balanced portfolio -- let alone an all-stock one -- would stay the course that long? But prolonged downturns do happen, as was the case in Japan through most of the 1990s. BMO Harris Bank's Don Coxe calls such phenomena "triple waterfalls" -- a 10-year boom in a particular asset class, followed by 20 years of drought.

If you're temperamentally equipped for a huge loss but unable to cope with waiting for the recovery, you may make what Kirby terms "a regrettable investment decision."

Kirby's article is at www.journalfp.net, or link to it from his site, www.dimensionalplanning.ca. In Monday's Advisor Post, I'll look at the implications of Kirby's paper for financial advisors.