Of all the questions a portfolio manager can ask, one of the most important is this: how much risk can you handle?
Risk is usually defined as variance in prices. This is convenient, because it allows us to quantify it. Long-term bonds are more risky that short-term; junk bonds are more risky than investment-grade; stocks are more risky than junk bonds—because their prices move around more.
But this misstates the issue. Lots of investors don’t worry about daily or monthly price changes. They want a stable income stream and a gradually growing level of capital. For these—and perhaps most—investors, anything that might threaten income or capital in the long run is meaningful. The problem we face is that many possible scenarios may unfold: more things can happen than will happen.
Diversification is an admission of our ignorance of the future. Another is making sure our decisions are reversible. How hard is it to back out of a mistake? Liquid investments like stocks and bonds make it quite easy. Others, such as annuities or hedge funds, can make it quite costly.
The past is not prelude, and history is not destiny. The sources of uncertainty today are manifold, and the keys to handling them are diversification, control, and transparency. We simply don’t know what the future holds. Anyone who tries to claim otherwise is selling something.
Douglas R. Tengdin, CFA
Chief Investment Officer
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