Investment Risk is the Chance of Underperformance

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"It is only the price on the final day that counts." — Warren Buffett

Three weeks ago, I introduced the concept of behavioral portfolio management (BPM) as a way to build superior portfolios. The next week, I discussed the first basic principle underlying BPM: Emotional crowds dominate market pricing and volatility. Last week, I presented the second basic principle underlying BPM: Behavioral-data investors can earn excess returns.

In this article, the fourth in a series of five, I will discuss the third and final basic principle: Investment risk is the chance of underperformance.

What is BPM?

BPM posits that there are two categories of financial market participants: emotional crowds and behavioral-data investors (BDIs). Emotional crowds are made up of investors who base decisions on anecdotal evidence and emotional reactions to unfolding events. Human evolution hardwires us for short-term loss aversion and social validation, which are the underlying drivers of today’s emotional crowds. On the other hand, BDIs thoroughly and extensively analyze behaviorally driven price distortions and build portfolios based on these distortions.

Basic principle III: Investment risk is the chance of underperformance

The measures currently used within the investment industry to capture investment risk are really mostly measures of emotion. In order to deal with what is really important, let’s redefine investment risk as the chance of underperformance. As Buffett suggests, focus on the final outcome and not on the path travelled to get there.

The suggestion that investment risk be measured as the chance of underperformance is intuitively appealing to many investors. In fact, this measure of risk is widely used in a number of industries. For example, in industrial applications, the risk of underperformance is measured by the probability that a component, unit or service will fail. Natural and manmade disasters use such a measure of risk. In each situation, the focus is on the chances that various final outcomes might occur. In general, the path to the outcome is less important and has little influence on the measure of risk.

In an earlier article I reviewed the evidence regarding stock market volatility and showed that most volatility stems from crowds overreacting to information. Indeed, almost no volatility can be explained by changes in underlying economic fundamentals at the market and individual stock levels. Volatility measures emotions, not necessarily investment risk. This is also true of other measures of risk, such as downside standard deviation, maximum drawdown and downside capture.