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June 20, 2008 Definition of Risk: Yours vs. the Mutual Fund Manager’s
- What is the discrepancy between the definition of risk for a mutual fund manager and the definition of risk for an individual?
- And why is this significant? What impact will this discrepancy have on your retirement income?
Hello, and welcome to 21st Century TV at 21stcenturyincome.com. The topic today that I am speaking about is the definition of risk. Whose definition of risk—the mutual fund manager’s or yours?
So oftentimes when I am out lecturing and speaking to clients or pension plan clients, I’m talking about “21st century income.” “21st century income” means that you have to generate income from your investments for many years out into the future. Many years out into the future has many dangers, many strengths and many opportunities.
A mutual fund manager’s definition of risk:
Deviating from the benchmark
One of those dangers is this disconnect between the person who has the money—you—and the person who is managing the money—either a mutual fund manager, an investment manager, or an investment advisor—and how they are defining risk compared to how you are defining risk. Let’s talk about a mutual fund.
How does a mutual fund define risk?
Let’s say that you have a four- or five-star mutual fund. Four or five stars would mean that it has very good performance—has a very good past performance. That manager is going to be judged against what’s called a benchmark or an index. For golfing, we would call it par. That’s how they will be judged.
If that manager should decide that they need to deviate from the index or they want to deviate from the index perhaps because investment conditions might dictate that, they have a risk. The risk is that they may underperform the benchmark, underperform the index. If they do that, all sorts of mostly bad things happen. The fund could perhaps lose some of its stars. If it loses its stars, it may lose assets. Assets equal paychecks for people who are managing the funds. The marketing department of the fund will come to that manager and say, “You really can’t do this because this is not what we are out promising our investors.”
An individual’s definition of risk: Losing money
The mutual fund manager when considering risk lives in a very different world than the world of the individual. The individual—and we have many years experience working with clients and I think I can say for all of them—defines risk as losing money, as losing significant amounts of money. When you are in the income mode, or “disinvesting” mode, as opposed to accumulation mode, significant losses of principal have really catastrophic effects on the amount of income you can generate in those future years.
It is a really, really important topic to understand who has what risk and who is defining what risk is for yourself and, of course, for the mutual fund manager or the investment advisor. If you ask pretty much any mutual fund manager, or call up the fund or look at their reports, you’ll see that there are lots of charts, lots of things that discuss risk, but none of them really discuss the real risk of losing money. And the real risk of losing money also from unforeseen events. That’s going to be a future subject called black swans and white rhinos. Thank you.
