Morningstar Magazine - August/September 2018 - 8

Dispatches

Remember Risk?
It's time to revisit the
risk exposures lurking
in portfolios.

Phillips Curve
10

The Fund World's Achilles' Heel

The Big Surprise

An Equity Squirrel Discovers Bonds

Policy
SEC Takes Stance on Advisor Conduct

LETTER FROM THE BOARD

Ben Johnson

Ivory Towers

The Old Squirrel

Behavioral Insights
16

Easing the Retirement Crisis

Americas
Greater Europe
Australia & New Zealand
Asia

Global Briefs
24
28
29

Do you remember what risk feels like? While the
market has hit a pothole or two during the current
bull run, the ride has generally been smooth.
Many-myself included-probably have a hard
time remembering just how nerve-wracking
the last bear market was.
The exhibit at right plots the trailing three-year
standard deviation of the S&P 500 from
March 1939 through the end of April 2018. At
present, this measure of stock market volatility has
been trending below its long-term average
for 68 months. This marks the third-longest stretch
of below-average volatility for the index dating
back to 1939. The next longest period lasted
75 months, from March 1956 through May 1962. So,
the current streak is unprecedented in the
experience of most investors.
Are you and your clients ready for when
volatility rears its ugly head again? Here,
I'll help you get reacquainted with risk: defining
it and discussing how it's measured, how
investors experience it, and how they can try
to manage it.
What Is Risk?

The most common definitions of investment
risk are rooted in uncertainty. How likely is it that
the returns on an investment will deviate
from the expected returns, and by how much?
There are a variety of ways to measure this
likelihood, the most common of which I mentioned
earlier: the standard deviation of returns.
This figure helps investors understand how widely
returns may fluctuate around their average.

Morningstar August/September 2018

It is a metric that is simple, widely accepted-
and deeply unsatisfying.
Standard deviation falls short in a number
of ways. It treats downside risk (the bad kind) and
upside risk (the good kind) as equals. Also,
standard deviation doesn't measure the shape of
the distribution, nor does it directly size the
magnitude of tail events-those episodes that
result in the greatest euphoria or most acute gut
rot. Of course, other risk measures address
these shortcomings. Measures that differentiate
between good and bad volatility include the
Sortino ratio and Morningstar Risk. The Sortino
ratio is a variant of the Sharpe ratio, the most
common measure of risk-adjusted returns. Both
ratios include excess returns over the riskfree rate in the numerator. But while the Sharpe
ratio features standard deviation in the
denominator (which, again, treats good and bad
risk as equals), the Sortino ratio divides only
by downside deviation. This gives a more accurate
picture of an investment's return per unit of
"bad" risk. Morningstar Risk looks at risk exclusively.
It doesn't ignore good risk entirely, but instead
places greater emphasis on bad risk. This
measure-which is calculated relative to funds'
Morningstar Category peers-is baked into
the Morningstar Risk-Adjusted Returns that are
the basis of the Morningstar Rating for funds.
While both of these measures differentiate
between good and bad risk, they still don't capture
the worst of the worst.
The most common way to size the sting in
the left tail of the distribution of returns (the bad
one) is maximum drawdown. Maximum
drawdown captures the peak-to-trough decline
of an investment over a given period. While
not a worst-case scenario (that would be losing
everything), it can provide a sense of just
how much pain might be in store in a bear market.
While all of these measures of risk have
some degree of utility when it comes to framing
investors' expectations, I think they're
still inadequate. I don't believe that risk can
be properly measured in a spreadsheet.
What Is the Real Risk?

Real risk lies in how we respond to the ups and

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2018