Morningstar Advisor - February/March 2009 - (Page 12) On Topic How Do You Gauge and Measure Risk? Let us know your thoughts at magazine_editor@morningstar.com On an individual investment level, we look at up/down capture, performance during bear markets, and straight volatility (standard deviation). On a portfolio level, long-term correlation is the most important factor. For asset classes, we look at long-term valuation levels. For example, we use a lot of John Hussman’s and Robert Shiller’s techniques when it comes to U.S. equity valuations. This is essentially the measure of risk; higher valuations mean greater risk. Kurt Box Cypress Advisory Services Houston, TX Did these measures prepare us for the meltdown? Yes and no. For the most part, individual-investment risk-assessment tools failed. Of course, by using equity-based mutual funds that concentrate on stock quality (such as Jensen Fund JENSX and Sound Shore SSHFX), we lost less in those asset classes than others did, but I wouldn’t call this a victory. On the portfolio level, long-term correlation failed miserably. Every asset class got crushed. It’s the first time in at least 50 years that this has happened. We had thought that portfolio-level correlation was one of our most important and powerful tools. On an asset-class level, analyzing long-term valuation levels worked. We recognized in 2003 that U.S. equities were overvalued and warned clients about it. I even wrote an article titled, “The Bubble Is Back.” But it was the implementation of this perspective that was difficult—which leads us to a risk that Jeremy Grantham has spoken about at length: career risk. Dealing with it is not enjoyable. In fact, it stinks! In 2003, we were a small firm, building our business. We allocated less to U.S. stocks than the average investor did, but had we truly followed our thinking on the valuation levels we were seeing then, we would have been much more conservatively invested. Why weren’t we? Because it would have been hard to attract new clients and difficult to retain current clients. We were caught in a pretty tight spot. Today, our firm is big enough and our client relationships strong enough that this factor will not be a concern going forward. As an aside, our clients have done much better than most investors, incurring what I would term “easily recoverable” losses. We have not lost a single client. One thing I’ve learned from this crisis is that our clients appreciate honesty. I have told them exactly what I am saying here about career risk. On the morning of Nov. 21, which was the market’s bottom, I sent out an e-mail titled, “Mistakes Made, Lessons Learned and Where Do We Go From Here?” As it turns out, my timing was pretty good! 12 Morningstar Advisor February/March 2009
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