Morningstar Magazine - August/September 2018 - 9

downs in the market. The volatility that the above
numbers attempt to explain is the net result
of the actions of flesh-and-blood human beings.
We are all responding to signals from our
environment (that is, one another). These signals
are being generated and interpreted by a hunk of
gray matter that is wired for survival. We are
risk-averse beings by nature. The real risk is that
we do the wrong thing at the wrong time and
put ourselves off the course toward reaching our
goals. It's impossible to convey that with data.

assets likely have a greater ability to take risk, but
they may wish to preserve their capital and,
thus, be less willing to assume more risk. Investors'
ability to take risk is also time-horizon dependent.
Recent college graduates contributing to
their employer's 401(k) program for the first time
have ample ability to take chances, given
that they likely have decades to save and invest
before they retire. Investors nearing retirement
may have relatively less ability to take risk
as they transition from accumulating financial
assets to relying on them for retirement spending.
None of these considerations is captured in
standard risk measures.

This concept of risk is absurd to measure because
it is deeply personal. How investors experience
and respond to risk will vary depending
on personality, circumstances, and experience.
Investors' risk appetite may fluctuate with the
market. It might also change with time.
Investors' risk tolerance is driven in part by
personality. Some people are wired to seek out risk,
be it in the markets or by jumping out of an
airplane. Others much prefer to play it safe, with
their feet firmly on the ground. Then there are
the skydivers who keep their cash under a
mattress and the actuaries who like to bet on the
ponies after work. The point is: Risk is personal.
Of course, investors' circumstances also affect
their willingness and ability to take risk. Investors
who have accumulated substantial financial

Investors' experience will also influence their
relationship with risk. People who have lost vast
sums in the market in the past may be uneasy
about taking risk in the future. Serial entrepreneurs
may be more comfortable with risk than company
men and women.
Attitudes about risk will shift with the markets
and evolve over time. Ask me now, years into a bull
market, during a period of relative calm, to
rate my willingness to take risk, and I'll tell you I'm
happy to pour it on. Ask me nine years and two
months ago, and I'd probably have said "No thank
you." Our attitudes toward risk are always
changing. While in March 2009, I'd probably have
passed on taking on more risk, the next time

Standard Deviation of the S&P 500 Index Over the Decades

the market tanks, I'll think back to what a
tremendous buying opportunity it was and (I hope)
be more opportunistic.
How to Manage Risk

There are a number of ways to manage investment
risk. I would put them into three buckets: asset
allocation, investment selection, and behavior.
Ideally, the first two should optimize for the third.
Perhaps the most effective way of managing
risk is to select an appropriate mix of assets.
Investors with a higher threshold for pain should
favor stocks. Those who are more squeamish
should lean toward bonds and cash. Striking an
appropriate balance is tricky. Just because
an investor doesn't like the ups and downs of the
stock market doesn't mean that she can afford to
skip the ride if she wants to meet her goals.
At this point in the market cycle, it makes
sense to revisit asset allocation. Given stocks'
relative performance over recent years,
odds are that many investors are heavy on stocks
and light on bonds. If this is the case, it may
be time to rebalance back to a more appropriate
mix. The right combination will ultimately
depend on many of the circumstances described
above (risk tolerance, ability to take risk,
personality, experience, and so on).
Investment selection is another lever investors
can pull to ratchet their risk. Large-cap stocks are
generally going to be less risky than small caps.
U.S. stocks will be less volatile than emergingmarkets stocks. Government bonds are safer than
%
corporate credits.

35%
30

Trailing 3-Year Standard Deviation

25
20
15.62

Average

10.26 10

5
03/1939

03/1949

03/1959

03/1969

Source: Morningstar Direct. Data from March 1939 through April 2018.

03/1979

03/1989

03/1999

04/2018

Finally, one of the most important sources
of risk is the one we look at in the mirror each day.
Poor decisions regarding asset allocation
and/or investment selection can easily put us off
course. As such, the choices made regarding
the first two buckets should optimize for behavior.
The best portfolio is the one you're most likely
to stick with the next time things get hairy in the
markets. Trying to solve for this is the best way
to manage the biggest risk of all. K
Ben Johnson, CFA, is director, global ETF research, with
Morningstar and editor of Morningstar ETFInvestor. He is a
member of the editorial board of Morningstar magazine.

global.morningstar.com/Morningstarmagazine

http://global.morningstar.com/Morningstarmagazine

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