WEST CAPITAL INTERNATIONAL JAPAN: THE MEANING OF RISK

WHAT IS THE MEANING OF RISK? THAT DEPENDS ON WHO YOU ASK

The word risk is defined as the relative potential of gaining or losing something that has value. Another way to look at it is a deliberate interaction with uncertainty. An astronaut might consider risk to mean the dangers at launch and reentry or the long-term health repercussions after a lengthy period in space. The primary and immediate risk is engine failure at liftoff and that is why it is given greater attention. The primary risk for an individual investor is the risk of running out of money during their lifetime.

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THE COST OF CERTAINTY

Allianz Life Insurance Company ran a survey of over 3200 people ranging from 44-75 in age. What they discovered was that 61% of respondents feared outliving their money more than they feared dying. This is not as dramatic as it first appears. For people nearing retirement, having insufficient money can mean anything from the loss of independence and having to move back in with children to the more drastic situation of having to live on cat food, as depicted by Logan Mountstuart in the British classic, Any Human Heart. Even more concerning was the fact that people’s estimates of how much they would need to save to achieve their income needs in retirement was off by more than 50%.

If running out of money is the number one risk to investors, then all other investment related risks must be subordinate. Let’s consider the implications of this statement. Hypothetically, imagine that a West Capital International client and their advisor decide that an overall asset split of 60% stocks and 40% bonds is the ideal mix to best minimize the risk of running out of money during their lifetime. Logic dictates that all other issues of risk preference for this investor are secondary to this planned asset allocation. On a day to day basis, holding 100% cash can feel most comfortable. Putting 60% of one’s assets into the stock market is not always going to feel like a walk in the park, especially when bombarded with 24 hour news headlines in a volatile market. The challenge in this scenario is that an investor’s desire to minimize their short term emotional discomfort can cause them to make decisions that in fact increase the risk of running out of funds over the long term.

Studies have shown that people like to gamble in casinos because the outcome of a decision is known immediately. In many other aspects of life, we make a decision and have to live with the uncertainty for a long period of time – did I chose the right career? The right spouse? Attending to one’s finances is just another aspect of life, and as in many others, certainty is comforting but often expensive. Most investors must come to terms with a trade off: their desired level of certainty cannot meet their long term monetary needs. In other words, certainty is comforting but expensive and successful investors accept a balance between predictability and their long term goals.

Most Western governments have accepted the math in this trade off, and have enacted pension fund laws encouraging equity investments. The rational is simple: treasuries and other cash equivalents provide certainty against capital risk, but they offer such low returns that that it is also certain that most investors would have insufficient savings to retire comfortably and a high probability of running out of money during their lifetimes. Japan is another country facing this, having both an aging population and very low interest rates over the last decades. Governments are forcing pension funds to take on greater investment risk to mitigate the risk of people running out of money. They are acknowledging legislatively the primary investment risk, even though this means forcing volatility on constituents.

At West Capital International Japan advisors spend a great deal of time with new clients helping them to understand all elements of risk when establishing their investment objectives and risk tolerances, which are intertwined. Acknowledging and working through the various aspects of risk can be very uncomfortable for people, but it’s time well spent and pays off down the road. Astronauts spend years calculating and planning for risks, long before being measured for their first space suit. Investors can certainly spend a few hours truly understanding the risks they can tolerate before the fun starts in the market.