Understanding and Managing Investment Risk


In the investment world, risk generally is related to uncertainty. It refers to the possibility that you might lose your investment, or that an investment will yield less than its anticipated return. Every investment carries some degree of risk because its returns are unpredictable. The more unpredictable its returns—the riskier the investment is considered to be.

Within this framework, there are multiple ways of viewing risk. Modern Portfolio Theory (MPT), the basis of most portfolio planning processes, views risk as being an evenly distributed set of returns (standard deviation) from an anticipated return (mean). However, a concept sometimes referred to as Post-Modern Portfolio Theory (PMPT) also has begun to receive attention. It focuses primarily on downside risk: the possibility of loss, or of not meeting a specific investment target; i.e. the statistical likelihood of a negative outcome.

There are also various behavioral studies that assert losses have a more emotional impact than an equivalent amount of gains. For example, one would think that an investor would be equally satisfied with an investment that appreciated $5,000 to one that gained $10,000 and then lost $5,000. In both situations, the end result was a net gain of $5,000.  However, despite the fact that the outcome was the same, most investors would value the gain of $5,000 over the higher initial gain combined with a subsequent loss.

While not grounded within PMPT or any behavioral theories, the investment approach of Legacy Trust has consistently placed strong emphasis on managing downside risk via our portfolio construction and manager selection process.  We rely on stochastic modeling of investible asset classes that are not perfectly correlated, generating thousands of potential outcomes that determine the probability of realizing many different investment results, especially the probability of outcomes falling below the anticipated rate of return.

In manager selection, we obviously look at the historical performance of the strategy relative to its benchmark and peer group, yet closely examine the underlying characteristics of the performance record – especially the ability to protect assets in periods of negative returns.  An additional review of the soundness of the approach and depth of the firm’s investment team provides confidence that the performance characteristics, especially the downside capture rate, can be repeatable.
The upward linear trajectory and absence of meaningful volatility in the markets of the past three years has created complacency in certain corners of the investing public.  Any experienced advisor will remind all that turbulence will eventually return and the ability to preserve accumulated value will be the highly sought attribute of professional investment managers.