What is Your Road to R&R?

The perfect time to focus on R&R during the final days before the inevitable post-Labor Day rush. 
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Ahhh…. late summer.  The perfect time to focus on R&R during the final days before the inevitable post-Labor Day rush.  While Rest and Relaxation are hopefully a given for all of us, I’m referring to my other favorite R&R: Risk and Return.

 

Risk and Return – the two foundational pillars of investing.  Risk is always mentioned first when we talk about this dynamic duo.  However, it’s Return that gets all the glory.  Consider your own day.  How much time do you spend analyzing and thinking about your investment Return – where it has been, where it is going, how it compares to others, and how to make it higher?

 

How much time do you spend thinking about Risk?  If we are being honest with ourselves, most of us naturally gravitate toward working on the Return side, unless we are dedicated Risk professionals.  And who could blame us?!  Return is the obsession of our industry.  It is typically one straight-forward number that measures how we are meeting our goals, how we are judged, and maybe even how we are compensated.

 

So, what about Risk?  Mentioned first, yet thought of second?  What do we even mean by Risk?  If you ask for the Risk of your portfolio, most likely you will either get many clarifying questions or many numbers.  No wonder it’s easier to focus on Return!   However, answering the question of what is Risk can help us think about the best ways to meet our Return goals, even before we calculate anything.

 

Within the R&R framework, Risk is most often understood as the volatility of Return.  As we know, volatility is typically calculated as the standard deviation from the mean.  This measurement of Risk provides insight into the magnitude of swings in a return series.  The adage of equating higher Return with higher Risk uses this measure.  It implies that to achieve higher Return in the long-term, one should expect larger variability in realized Return over shorter periods and a greater range of possible expected Returns (positive and negative) going forward.

 

There are mathematical shortcomings of standard deviation as the end-all-be-all Risk measure.1 However, the concept of Risk as understanding the pattern of Returns is important.  A single Return number measures only the endpoint, with no information about the path.  For example, compare the excess return of the Bloomberg Barclays Aggregate Index for year-end 2020 with year-to-date 2021.  Both are +0.28%2.  Same endpoints.  Shockingly different paths.  Same Return, obviously different Risk.

 

For many, “standard deviation of Return” is not the most helpful answer to, “What is Risk?” Perhaps more relevant to portfolio goals is the Risk of principal return, or the Risk of being able to meet cash flow needs, or the Risk of not properly hedging a liability on the balance sheet, or the Risk of maintaining capital requirements for a regulator, or the Risk of protecting real value in an inflationary environment.

 

Quality Risk, Liquidity Risk, Interest Rate Risk, Mark-to-Market Risk, Sector Risk, Issuer Risk.  Just to name a few!  Each of these Risks impacts a portfolio’s objectives.  Even if one is not explicitly emphasized for a specific portfolio goal, each Risk implicitly impacts the overall volatility, or path, of Return.

 

By breaking down the path into Risk steppingstones, we can ensure we are deliberately exposed to those Risks we believe are undervalued and reduce undesired or unintended exposures.  Understanding and optimizing the many rocks of Risk is the precursor to generating Return.  So, it makes sense Risk is the first step in R&R.

 

After identifying these Risk stones, we can quantify them individually.  The size we choose to reflect in a portfolio often will dictate the magnitude of the Return path.  Big boulders (large Risk positions) could lead to a bumpy, wide highway (large swings in Return.)  Likewise, tiny pebbles (small Risk positions) could produce a smoother, narrow footpath (small swings in Return.)

 

As we come back from our Labor Day weekend reprieves, whether it be from hiking trails, boardwalks, cart paths, bike lanes, cobblestone streets, hidden alleys, interstates, runways, gravel roads or sidewalks, let’s breathe in and enjoy those moments.  When we mentally pivot to how we will generate/optimize/meet/beat Return goals, let’s not forget about Risk.  Carefully defining and sizing the steppingstones is the first step to navigating our path through the last stretch of 2021 and beyond.

 

Endnote: To be thorough and robust, it is worth highlighting that the question “What is Return?” has multiple answers, too.  We can save that for our next chat.  First things first.  Risk and then Return.

 

1One pitfall of standard deviation is having enough observations to calculate a meaningful statistic.  Another issue is that standard deviation is best suited to describe a “normal distribution,” meaning the distribution of returns is symmetric around the mean with most observations occurring close to the mean and limited observations in the “tails” far from the mean.  As finance practitioners, we know returns are often skewed and, during periods of market stress, returns can have “fat tails” with many observations far away from the average.

 

2Source: Bloomberg as of Aug 11, 2021

Sources: Bloomberg Barclays. Data as of 08/11/21. The above examples are for illustrative purposes only.  Actual results may differ. The securities mentioned are for illustrative purposes only. This is not a recommendation to purchase or sell the securities listed. Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable.  This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product.  No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.

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