By Rusty Vanneman, CFA, CMT – Chief Investment Officer, Orion

Risk can be defined in different ways, but the ultimate risk is not meeting one’s investment objectives. The biggest reason investors do not meet their goals is an inability to stick with an appropriate investment plan.

There are two primary reasons investors get off course. One is that an investment portfolio didn’t behave as expected. The second is that an investor’s return expectations were unduly influenced by recent performance. Let’s discuss both.

Investments Not Performing as Expected

Risk Scoring of Investors

In the investment profession, investor risk tolerance (the financial and emotional capacity to take stock market risk) is typically profiled with risk scores from zero to 100. If an investor scores a zero, they are very conservative and probably shouldn’t be investing! If an investor scores a 100, they are very aggressive, suggesting they have a long-term investment horizon and are very knowledgeable and comfortable with stock market risk. The 100-score investor’s portfolio would then assume 100% (or more) total market risk, and a zero-score investor’s portfolio would assume zero stock market risk.

(“Total market risk” should be defined by the global stock market, which is the broader investment opportunity set, not a subset of the global market, such as U.S. large-cap stocks listed on the S&P 500.)

To drive the point home: If an investor scores a 100, they would be comfortable with 100% market risk. If they score an 80, they would be comfortable with 80% market risk; with a score of 50, they’d be comfortable with 50% market risk, and so on.

For an investor’s expectations to be met, they need an investment portfolio with a risk level that matches their risk score.

Risk Scoring of Investments

Investments, meanwhile, have a wider range of risk scores and will often score outside the zero to 100 range. An easy way to understand this is if the “total market risk” is defined by the entire global stock market, then it’s obvious that some stocks are riskier than the overall index and others are less risky.

It’s rare that two total equity portfolios have identical risk. For example, one all-equity portfolio could comprise all volatile, small-cap technology stocks, while another all-equity portfolio could be entirely invested in stable, large-cap consumer staples stocks. These portfolios might both be all-equity, but their risk scores will differ significantly from the overall market.

Yet another example is an investment portfolio that may be leveraged, perhaps taking three times the risk of the market. Obviously, its risk score should not be 100; it should be closer to 300, depending on what it’s leveraging.

Risk Changes All the Time

Another crucial consideration for investors when building investment portfolios is the fact that investment risk scores change over time. In fact, they can change a lot over relatively short periods of time, and that can make a big difference to how portfolios behave. Risk-scoring methodologies should reflect that, ideally being updated as frequently as possible.

The table below is an example of why more frequent risk scoring is important. When we review the global market and break down standard investment risk statistics over the last one- and 10-year periods, we see significant changes.

This may surprise many investors, but non-U.S. stocks have been less risky/volatile than U.S. stocks over the last year. For instance, the one-year beta, which is a measure of relative risk, for non-U.S. stocks, is only 0.76. That means non-U.S. stocks have had a bit less than 80% of the risk of the global equity market over the last year. Over the last 10 years, however, international stocks were more volatile, with a beta of 1.08.

U.S. stocks, meanwhile, have had 118% of the risk, while the 10-year average beta has been a bit less than 1.00. (The total U.S. stock market is defined by the total market Russell 3000. Note that the S&P 500 excludes small-capitalization companies and most mid-cap stocks, too.)

Why have these risk characteristics changed? The biggest reason is price volatility has sharply risen for U.S. stocks relative to non-U.S. stocks, at least for the indices that represent them. That is clearly different from historical market behavior. Investment portfolios should be managed accordingly, given this information, to match investor expectations.

Wrong Benchmarks

Another reason portfolios don’t behave as expected is investors may be matching them against the wrong benchmark. This is a common problem in the investment industry. An investment’s return and risk expectations need to be based on the typical asset classes the portfolio invests in. For instance, if a portfolio is balanced with a blend of assets classes, then simply matching it against an index of U.S. large-cap stocks, such as the S&P 500, doesn’t make practical sense.

If portfolios of different asset classes are being judged together, then a risk-based benchmark is a preferred way to understand risk and measure portfolio performance over time. In other words, if a portfolio has exhibited 50% of the risk of the global equity market (and assuming no change in investment philosophy or process), then it should be expected to have approximately 50% of the risk of the global equity market moving forward.