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18
C H A P T E R

What Is the Most Useful Definition of Risk

for Family Investors?
James Garland

I n an investment context, risk means the possibility of not having available the
money you need at the time when you need it.
This definition requires two elaborations. First of all, “need” is subjective.
k Some people may feel that they need a Rolls Royce, or a condo in Palm Beach, k
or a private jet. Others can lead happy lives without such luxuries. What do you
really need?
In addition, the probability of a shortfall is less important than the consequences
of that shortfall. Suppose that your twin children are about to enter college, that
they’ve been accepted to elite schools (“elite” meaning you’ll pay over $65,000
a year), and that you’ve accumulated an equity portfolio whose current value is
roughly the amount needed to pay their expenses for the next four years. The
portfolio is invested in just a few companies, and furthermore it’s leveraged with
margin debt.
The consequences of your hanging on to those securities are lopsided; if
the stocks continue to rise, you’ll make a few more dollars, but if they decline,
the kids may be headed for community college. The serious potential conse-
quences of continuing to hold these stocks makes this a very risky bet. But if
the consequences were minor – if this were play money, so to speak – then the
risk would be far less. Bill Gates doesn’t have to worry about his grandchildren’s
college tuitions. You may have to.

Volatility as a Proxy for Risk

The market values of financial assets are volatile. Investors understand that
stocks are more volatile than bonds and that real estate lies somewhere in

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120 Wealth of Wisdom: The Top 50 Questions Wealthy Families Ask

between. Therefore, in the most widely accepted hierarchy of risk, stocks are at
the top, followed by real estate, with bonds near the bottom.
Volatility can be a good proxy for risk, particularly in the short term, as
illustrated by the college tuition story just told. However, volatility is only one
dimension of risk, and sometimes volatility doesn’t even matter. If the stock
market goes down a lot this year, for example, that’s not at all a risk for you,
except if you’re intending to sell stocks soon to make a significant purchase.
Price declines matter only when people are selling. But because volatility can
be quantified, whereas other risks cannot be, economists and investment firms
have latched onto volatility as the sole proxy for risk. That’s an incomplete view
of the world.

Investment Models
To navigate through the fog of finance, academics use mathematical models.
Academics love models because they reduce very messy real-world living to sim-
ple formulae that can fit on a classroom blackboard. Some models are highly
respected. One, the capital asset pricing model, won its creators a Nobel Prize.
Use models, but don’t believe them. Models can be useful, but in only a
limited way.
First, the good news: some models (including the capital asset pricing
k model) describe how markets are supposed to behave, and such descriptions k
are useful in understanding basic principles, such as the virtue of diversification,
the equity risk premium, and so on.
But the bad news is that models fail in at least two important regards.
First, models fail to account for human nature. They describe how mar-
kets are supposed to behave, but real-life markets – not knowing the expec-
tations with which economists have burdened them – don’t behave that way.
A whole new field called behavioral finance has arisen to explain how investors
actually behave. Because real-life behavior cannot be described mathematically,
economists’ models are incomplete.
Second, many models assume that outcomes are normally distributed. In lay
terms, they assume that outcomes fit within what are known as bell curves. Bell
curves are good at describing normal circumstances, but circumstances are not
always normal, and abnormal circumstances are the dangerous ones. A simple
bell curve appears in Figure 18.1.
The black line plots investment returns on the horizontal axis, and the prob-
ability of earning those returns on the vertical axis. This bell curve is derived
from a commonly used theoretical model. The most likely outcomes are clus-
tered near the center (around the average); extremely low returns (at the left)
and extremely high returns (at the right) are quite rare.
But real life looks more like the gray line. In many situations, including in
financial markets, extreme events happen more often than the models predict.

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What Is the Most Useful Definition of Risk for Family Investors? 121

high >>
Theoretical Outcomes

PROBABILITY

Real-Life
Outcomes
<< low

<< low RETURN high >>

Figure 18.1 Theoretical outcomes versus real-life outcomes.

This is known as a “fat-tail” problem, because events at the left and right ends
of the curves – at the tails – are more common than expected and are often
quite consequential. The fat-tail events with which we’re most familiar involve
the weather. Hundred-year floods seem to happen not every hundred years, as
models would suggest, but rather once every decade or two.
The most extreme financial event in my lifetime was the October 1987 US
k stock market crash, when the S&P 500 Index declined by 23% in just one day. k
According to standard stock market models, that 23% single-day decline should
happen only once in every three trillion years.1 That was a fat-tail event!

Investing for Income

A small number of investors have very long time horizons and have enough
capital that they can afford to live off the income that their capital generates.
This is a game changer. So-called “income investors” don’t have to worry about
market values at all. For them, all that matters is the stability and security of
their income sources.
In the United States, at least, dividends from equities (in particular,
from the S&P 500 Composite Stock Index) have been far more stable than
the market values of those equities. For example, there has been only one
peak-to-trough decline in S&P 500 dividends of more than 5% since 1950
(i.e. a 21% drop in 2008–2009), and dividends recovered from that particular
decline in just three years. There are simple ways to self-insure against such a
decline – for example, by holding some bonds that can be cannibalized to fill
in any dividend “potholes.”

1
This number comes from David F. Swensen, Unconventional Success (New York: Free Press, 2005),
p. 186.

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122 Wealth of Wisdom: The Top 50 Questions Wealthy Families Ask

Most investors – e.g., people who are saving for their retirements, and
families who have established private foundations – do have to worry about
market values though, and managing market values is a difficult task. Income
investors inhabit a lower-risk world. Because the rest of the investment universe
is obsessed with market values, income investors should ignore most of what
other investors and the media have to say.

Primary Sources of Risk

For investors with short time horizons, volatility is a risk. This is true also for
longer-term investors who intend to liquidate their investment assets, such as
retirement investors.
However, it’s not always true that these investors need to fear market
declines. Younger investors should welcome bear markets, because bear markets
will enable them to accumulate shares and bonds at favorable prices. It’s only
dissaving investors, such as retirees, for whom bear markets are a worry.
For investors with long-term horizons, however, the risks are different. The
primary source of returns for long-term equity investors is the profits that their
corporations earn. As a result, the primary risks for long-term investors are risks
that threaten corporate profits. Some of them are the following.

• Economic risks include such events as recessions and depressions.

k • Business risks matter particularly for families who are undiversified, i.e. k
that still own one or more operating businesses.
• Governmental risks are threats from things such as poor governmental poli-
cies or weak property rights, or from blatant actions such as expropriation
of assets.
• Hyperinflation is self-explanatory. Modest inflation generally is not a prob-
lem, at least for equity investors, because profits and dividends tend to
keep pace with increases in the cost of living.
• Environmental risks may be important in the future if some predicted
effects of climate change come to pass.

Well-to-do investors have a moral obligation to try to improve the commu-

nities and nations in which they live. A happy paradox is that fulfilling this
obligation, in the long run, may benefit these investors as well as the world
at large.
But for investors who are reading this book, no matter what your time
horizon, the biggest risk may be you. Have you made a long-term investment
plan? Is it any good? Have you stuck by it? Were you caught up in the Internet
Bubble? Did you panic during the Great Recession of 2008–2009? Do you
pay attention to mundane but potentially corrosive issues such as costs?
Do you trade or change managers too often? Do you search hungrily for
self-proclaimed “experts” to guide you on your way? Have you inoculated

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yourself and your family members against common behavioral errors such as
overconfidence, trend following, anchoring, and so forth?
Contrary to any claims it may make, your brain is not always your best friend.
If you fail to understand the errors that your mind can make, your mind will
make them.

How to Reduce Risk

Set clear, achievable, and meaningful objectives. Risk can only be defined in terms
of your particular objectives. For example, if you seek income, then mar-
ket value fluctuations will matter very little or perhaps not at all.
Prepare. Study history. (As Jack Bogle of The Vanguard Group once said,
“Learn from the experience of others – it’s cheaper.”) Educate your fam-
ily members. Help them understand (among other things) how markets
work, the industry’s potential conflicts of interest, why minimizing costs
is important, and the traps that lurk along the way.
Understand yourself. Study behavioral finance.
Diversify. The way to make a fortune is to invest in just one company – the
right company. The way to preserve that fortune is to diversify.
And finally, save more and spend less. Spending less than one earns is a magical
way to lessen the risk of running out of money.
k k
One Final Word
To boil all of this down to its core, the fundamental objective of investing is to
survive. There are no guarantees in investing. Diversify your life as well as your
investments. Get a good education, find a good job, and make good friends.

Questions for Further Reflection

1. If we have to choose between higher potential returns and lower price
volatility, how do we choose?
2. Can’t hedge funds protect us from market downturns? What about
absolute-return funds?
3. How can we protect ourselves against fat-tail events?
4. How broadly should we diversify?
5. How can I keep our family from panicking during bear markets? From
jumping onto fads?

Additional Resources
Charles Ellis, Winning the Loser’s Game (New York: McGraw-Hill, 2017).
There are two messages in this book: first, that markets are efficient, and there-
fore investors should not shoot for better-than-market returns; and second,
that investors need to take charge of the entire investment process.

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124 Wealth of Wisdom: The Top 50 Questions Wealthy Families Ask

Burton G. Malkiel, A Random Walk Down Wall Street (New York: W.W. Norton,
2016).
The classic all-in-one investment manual.
James Montier, The Little Book of Behavioral Investing (Hoboken, NJ: Wiley, 2010).
The best short guide to the many ways that smart investors can (and will!) make
foolish errors.
Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists (Prince-
ton, NJ: Princeton University Press, 2002).
This is a history of national stock and bond market returns during the twentieth
century. The best such source around. One lesson from the book is that
North American investors have been fortunate – US and Canadian stock
market returns since 1900 have been among the best in the world. Will that
good fortune continue?
None of these are light reading, but if you care about your family’s investments,
make the effort. Keep an eye out for occasional good articles in the media or
on the Internet. For starters, almost any articles by Charles Ellis, or Burton
Malkiel, or Meir Statman (a specialist in behavioral finance) will be worth
reading. And watch for articles by the dean of financial columnists, Jason
Zweig, whose work resides these days at the Wall Street Journal.
k k
Biography
James Garland is former president of The Jeffrey Company, a family investment
company based in Columbus, Ohio. A Maine native, he graduated from Bow-
doin College in 1969 with a degree in music history. He worked for seven years
at NASA’s Goddard Space Flight Center in Greenbelt, Maryland, then returned
to Maine in 1976 to join an investment advisory firm as a securities analyst and
portfolio manager. He then moved to Ohio in 1995 to work for The Jeffrey
Company. He is the author of papers dealing with personal trusts, endowment
spending, and taxable investing that have appeared in the Financial Analysts
Journal, The Journal of Portfolio Management, and The Journal of Investing.