In the language of investment, risk is typically defined by the degree of volatility in the returns of an investment vehicle or asset class. One look at the Canadian Securities Administrators’ (CSA) risk classification methodology for investment funds reveals that prevailing school of thought.
But volatility-based risk determination can have drawbacks when considering investors’ actual objectives. “I like to say, with obvious exaggeration, that each of us wants two things in life,” wrote Meir Statman, Glenn Klimek professor of finance at Santa Clara University’s Leavey School of Business, in the Wall Street Journal. “One is not to be poor. The other is to be rich.”
Given that thinking, Statman said, the risk to an investor isn’t based on their portfolio’s volatility, but based on the prospect of it failing to satisfy their wants. While the difference in judgment could yield the same portfolio, that doesn’t happen in many cases. “Investing a portfolio in a money-market fund ensures low volatility, but it’s hardly a low-risk portfolio, since it almost certainly guarantees that it will fail to satisfy even the minimum wants,” Statman noted.
To illustrate how a wants-based approach would impact portfolio rebalancing, he used the example of an investor who wants mainly to be rich, and has a secondary want to not be poor. She meets the not-poor want with a “thin” 20% portfolio layer in bonds, and a “fat” 80% portfolio layer in stocks. Over the following month, stock prices rise and bond prices stay flat, the upshot for her being a 90-10 portfolio of stocks and bonds.
“Under the standard rebalancing approach, an investor would sell stocks and buy bonds. But that isn’t necessarily the case with wants-based rebalancing,” Statman said. “If the investor still thinks her not-poor wants can be satisfied with the bonds she currently owns plus her earnings potential, then she shouldn’t rebalance at all.”
He also presented a counter-example: an older retired person pursuing his main objective of not being poor with an 80% bond weighting in his portfolio. “Now suppose that during the following month stock prices increase while bond prices remain the same, such that now his portfolio consists of 30% in stocks and 70% in bonds,” he wrote.
Under the traditional approach, the investor would right the ship by selling stocks and buying bonds. But if he were to think and deem the not-being-poor layer of his portfolio sufficient, he’d leave the portfolio as is and have a better shot at the secondary objective.
Aside from the traditional focus on volatility, Statman also questioned the sense in using fixed-proportions portfolio rebalancing to adjust for mean reversion — above-average stock or bond returns being followed by below-average returns — and, theoretically, selling stocks or bonds at above-average prices and buying them at below-average prices.
“[S]tock and bond returns don’t follow predictable patterns,” he observed. Under the traditional method, many investors would have missed out on the near-decade-long bull market — and would have incurred taxes in taxable portions of portfolios as well as greater transaction costs, to boot.
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