Morningstar Advisor - April/May 2013 - (Page 37)

argue uncertainty because we were unprepared for such an event. But one could counter that it was a classic example of risk because several years before a similar attempt had been made on the same target by the same terrorist group. Was 2008 risk or uncertainty? Certainly, very few investors and institutions were prepared for the credit crisis. But one can go back in the data to find very similar events. Confronting Risk: A Stylized Illustration Define all possible outcomes. –22.9 –19.2 –15.5 –11.7 –8.0 –4.3 –0.5 3.2 6.9 10.7 14.4 18.1 21.9 Quarterly Returns Revisiting our histograms, it’s critical to note that they represent what the world might look like over a specific period of time. Investment returns are a function of many things but are literally indeterminate without time. Despite the convenient formalism of continuous time mathematics, all investments take place in a tick-by-tick, discreet world. Convert each outcome into an event by assigning it a probability. 25% 22% 14% 9% 5% 4% –22.9 –19.2 –15.5 –11.7 –8.0 –4.3 6% 4% 1% 3% 1% –0.5 3.2 6.9 10.7 14.4 4% 18.1 2% 21.9 Quarterly Returns Transform each event into a certainty-equivalent value. 25% 22% 9% 1% –53.5 1% 3% –26.3 4% 6% 4% –10.3 –0.5 5.7 9.8 4% 2% 12.6 Utility-Adjusted Returns feedback mechanism. Market participants are constantly processing information and making decisions on that information, which, in turn, has an impact on how the data is generated. In traditional statistics, the larger your sample size, the better. But in investments, a large sample size may encompass data that was generated via obsolete processes. For example, many would argue that using historical stock and bond returns before 1952 is invalid, because it was at that time Indeed, investor risk tolerance and risk capacity is always a function of time. Consider the target-date fund. Why decrease risk as you approach retirement? Well, one reason is that you’ve less time to substitute planned future consumption for current consumption. Less time means more risk. Time is money. In the Final Analysis 14% 5% Risk and Time the Fed allowed short-rates to float freely. Others would say that looking at bond returns before the early 1970s is irrelevant for forecasting the future, because the end of the gold standard and the advent of hyperinflation changed the likely distribution of bond returns. Many would argue for far shorter time frames. The definition of what is an uncertain event is, in and of itself, ambiguous. Was 9/11 an example of risk or uncertainty? Some would Risk is inescapable. If you choose to park your money under the mattress, you risk having the purchasing power eroded by a particularly nasty random variable: inflation. In fact, the “risk” of inflation is that it varies. If you knew for certain that prices would rise by 2.5% for the next 20 years, there’d be no risk at all. You’d adjust your planned consumption accordingly because you’d know for certain that each dollar would be worth 61 cents. This might be a bad outcome, but it isn’t risk. Ultimately, all investment decision-making is about risk—and uncertainty. This is what makes the discipline exciting and engaging. This is, presumably, why you’re here. K Hal Ratner is the chief investment officer, Europe, with the Morningstar Investment Management division. MorningstarAdvisor.com 37 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013