How to Minimize Uncompensated Risk

Contributor Scott Simon illustrates how reducing this risk can damp portfolio volatility and improve investor outcomes.

W. Scott Simon

 

There are lots of different kinds of investment risk, including inflation risk, credit risk and interest-rate risk. However, what I term modern prudent fiduciary investing–that is, the Restatement (Third) of Trusts and the Uniform Prudent Investor Act–is grounded in Modern Portfolio Theory. As a result, it’s concerned primarily with the nature of portfolio risk and how to diversify it prudently. So let’s see what that means.

The total risk carried by a portfolio of stocks–or a single stock or mutual fund, or fixed income investments, for that matter–can be separated into two kinds: uncompensated risk, which comprises about 70% of total portfolio risk, and compensated risk, which comprises about 30%.

Uncompensated risk reflects the news that may affect the market price of a particular stock or group of stocks in a unique way. For example, the departure of CEO Elon Musk from Tesla (TSLA) would likely depress Tesla’s stock price and perhaps affect the stock prices of other such companies as well.

Noble laureate Harry Markowitz, the father of Modern Portfolio Theory, recognized that when investments such as stocks are combined together in a portfolio, a correlation structure is formed among the stocks based on the movements in their respective market prices. Covariance, which formally expresses this correlation structure, describes how the prices of stocks in a portfolio move–up or down–relative to each other in response to news. News includes not only accurate but also inaccurate information, including rumors–all of which contributes to helping establish the market price of a stock at a particular point in time.

Markowitz found that including stocks in a portfolio with low or negative covariance to each other–that is, stocks that have dissimilar movements in their market prices relative to each other–minimizes uncompensated risk, thereby sharply reducing overall portfolio risk. What made Markowitz’s discovery of covariance so revolutionary is that it allowed investors to virtually eliminate uncompensated risk from their portfolios in a relatively easy and inexpensive way.

Because this avenue is open to any investor, financial markets won’t reward them for retaining this kind of risk. Such investors may even be penalized by the markets because retention of uncompensated risk always carries the threat of a dead-weight loss to a portfolio’s growth in value.

Restatement commentary makes clear that fiduciaries ordinarily shouldn’t retain uncompensated risk in portfolios under their care: “Because market pricing cannot be expected to recognize and reward an investor’s failure to diversify [uncompensated] risk, a [fiduciary’s] acceptance of such risk cannot, without more, be justified on grounds of enhancing expected return.”

The dangers of failing to shed a portfolio’s uncompensated risk are primarily twofold. First, there can be significant financial harm to investors such as beneficiaries–whether they’re trust-fund babies, participants in 401(k) plans, or nonprofit foundations and endowments. Second, there can be significant legal penalties for fiduciaries if they allow their beneficiaries to be so harmed.

Failure to diversify in order to reduce uncompensated risk ordinarily is a violation of both the duty of caution and the duties of care and skill. These three fiduciary duties together form the legal definition of “prudence” under modern prudent fiduciary investing. Any fiduciary violating this should, among other things, bear the Scarlet Letter of “I” for “Imprudence.”

Minimizing Uncompensated Risk 

Minimizing a portfolio’s uncompensated risk can significantly lower its volatility. Here’s why.

Average return is determined by adding up the returns from a series of periods and then dividing that sum by the number of periods; compound return, meanwhile, is determined by multiplying the returns from each period. It follows, mathematically, that a low-volatility portfolio will end up with more dollar wealth than a high-volatility portfolio because ending wealth is calculated by compound return, not average return.

The greater the volatility of a portfolio–that is, the random and therefore wholly unpredictable up-and-down gyrations in the values of the stocks comprising the portfolio–the more that volatility decreases compound return. Extreme–or even relatively moderate–volatility in percentage returns can affect dollar values dramatically. The following three examples demonstrate this.

Portfolio 1 has $10,000 in Year 1 and achieves a 10% gain. In Year 2, Portfolio 1 incurs a 10% loss. The simple average return at the end of Year 2 is 0% (+10% + -10% ÷ 2). That’s all very interesting, but people don’t live off percentages–they live off money. So in dollar terms, the 10% gain on $10,000 left Portfolio 1 with $11,000 at the end of Year 1 and the 10% loss on that $11,000 left it with $9,900 at the end of Year 2. So Portfolio 1 suffered a net loss of $100 over the two years.

Portfolio 2 has $10,000 in Year 1 and achieves a 30% gain. In Year 2, Portfolio 2 incurs a 30% loss. The simple average return at the end of Year 2 is, again, 0% (+30% + -30% ÷ 2). The 30% gain on $10,000 left Portfolio 2 with $13,000 at the end of Year 1 and the 30% loss on that $13,000 left it with $9,100 at the end of Year 2. So Portfolio 2 suffered a net loss of $900 over the two years.

Portfolio 3 has $10,000 in Year 1 and achieves a 50% gain. In Year 2, Portfolio 3 incurs a 50% loss. The simple average return at the end of Year 2 is, yet again, 0% (+50% + -50% ÷ 2). The 50% gain on $10,000 left Portfolio 3 with $15,000 at the end of Year 1 and the 50% loss on that $15,000 left it with $7,500 at the end of Year 2. So Portfolio 3 suffered a net loss of $2,500 over the two years.

Note the relationship between the volatility percentages of the three portfolios–10%, 30%, and 50%–and the impact they had on the dollar values of the portfolios–losses of $100, $900, and $2,500. While the volatility percentages of the portfolios grew fivefold–from 10% to 50%–dollar losses grew twenty-five-fold–from $100 to $2,500.

Hence, linear differences between the percentage losses of portfolios can generate exponential differences in resulting dollar losses. If instead of dollar losses a portfolio has dollar gains, those gains are reduced exponentially by portfolio volatility. So high portfolio volatility is bad all the way around–it not only magnifies losses but also reduces gains. There’s just nothing good to say about high-volatility portfolios. But portfolios that largely banish uncompensated risk are low-volatility portfolios.

Compensated Risk

Let’s not forget about compensated risk, which is about 30% of total portfolio risk. Compensated risk reflects the news that affects the market price of many–or all–stocks. Because the prices of stocks are affected, more or less, by the risk of a general rise or fall in the value of the stock market itself, compensated risk cannot be diversified away in a portfolio. It’s unavoidable by an investor who wishes to invest in the stock market.

So, unlike the fiduciary duty to minimize uncompensated risk, a fiduciary has no duty to reduce compensated risk because that kind of risk carries an expected (but not guaranteed) return. The principal way for a fiduciary to change the expected return of a rationally diversified portfolio (that is, one that minimizes uncompensated risk) is to raise or lower its level of compensated risk by investing either a greater proportion in stocks–say, 80%–or a smaller proportion–say, 20%. The level of a portfolio’s compensated risk is appropriate in a given situation as long as there’s a realistic prospect of realizing gain commensurate with the compensated risk assumed.

Conclusion

Markowitz found that a rationally diversified portfolio with stocks that have low or negative covariance to each other can minimize or even virtually eliminate the portfolio’s uncompensated risk and thereby significantly reduce its overall risk. That leaves a portfolio primarily with only compensated risk. A fiduciary is free to increase or decrease this kind of risk according to the level of expected return it wishes to shoot for, as long as that risk is appropriate given the facts and circumstances of the portfolio(s) under its care.

Markowitz’s notion of diversification is the only known free lunch in all of investing. As John H. Langbein, the reporter for the Uniform Prudent Investor Act and a professor of law at Yale University Law School explains: “One of the central findings of Modern Portfolio Theory [is] that … huge and essentially costless gains [can be obtained by] diversifying [a] portfolio thoroughly.”

The best way to partake of this free lunch is to invest in a portfolio that’s both broadly diversified–that is, across­­­­­­­­­­­­­­­­­­­­­­­­­ the asset classes in which the portfolio is invested–and deeply diversified–that is, within each such asset class. This kind of diversification is preferable because it’s the most efficient way to virtually eliminate a portfolio’s uncompensated risk.

That’s why Markowitz suggested in his seminal paper on “Portfolio Selection” in 1952 that his notion of diversification tends to promote investment behavior, while the then-prevailing notion of diversification tended to promote speculative behavior. In my view, fiduciaries that focus solely on return–without taking risk into account–are speculators, not investors. And no fiduciary with legal responsibility and liability for investing and managing other people’s money should be a speculator.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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