Risk-reward lessons from the boys of summer

Investors who have not saved enough to meet their objectives often look to their advisor for a miracle solution. How do you assess the risk of available investment choices?

Like being down a run in the bottom of the ninth inning, do you allow that sole runner at first base to attempt a steal of second? If there are two outs and the steal is unsuccessful, the game is over.

Stealing, like trying to grow investments significantly over a short time horizon, is risky. With apologies to non-baseball fans, we look at the lessons a Canadian baseball team has for investors.

When there is no choice

Inducted into the Canadian Baseball Hall of Fame in 2003, the Asahi club dominated West Coast baseball from 1917 to 1941. The pride of the Japanese-Canadian community overcame discrimination and lack of power with their pinpoint bunting and aggressive base running to win five Pacific Northwest and 10 City of Vancouver championships, becoming the city’s most popular team.

Asahi success depended not on home runs, but on advancing runners. Unlike Oakland Athletics’ general manager Billy Beane, of Moneyball fame, who feels that stealing bases is not worth the risk, the Asahi excelled at it because they had no choice. They lacked the power to score conventionally, and took advantage of every opportunity opponents gave them.

The math of stealing bases

The decision to steal is about measuring risk versus reward, something investment managers do every day.

A coach considers two things when deciding whether to steal second base:

• the probability of success (not being thrown out);
• the probability of scoring a run.

Probability of success is a function of the pitch time to home plate, how long it takes the catcher to throw to second and the base runner’s speed.

The probability of scoring a run depends on the base runner’s position and the number of outs.

With no outs, stealing second base improves the likelihood of scoring a run from 41.6% to 61.4% (see Table 1). If caught stealing, now one out, the probability drops to 15.5%. Because of this risk, Beane and other statistical managers only attempt to steal if the chance of success is greater than 70%.

Table 1: Probability of scoring a run during the inning (using 2010-2015 statistics)

Runner on	0 outs	1 out	2 outs
Nobody on base	26.8%	15.5%	6.7%
1B	41.6%	26.5%	12.7%
2B	61.4%	39.7%	21.6%
3B	84.3%	66.0%	25.7%

Source: Retrosheet

Knowing the probabilities lets the manager assess whether the risk is commensurate with the reward given the score, innings remaining, and the size of the prize (e.g., they’ll take more chances in the final game of the World Series).

The math of portfolio risk

Let’s say an investor wants to accumulate $200,000 in 20 years. Starting with $100,000 makes the job easier than starting with less; it’s like standing on third base with no outs. Table 2 shows the probability of getting to $200,000 using 8% and 6% annual return assumptions for three starting capital amounts and three levels of market volatility.

Table 2: Probability of accumulating $200,000 after 20 years with different market volatilities, 8% and (6%) returns

Starting capital	10% volatility	15% volatility	20% volatility
$60,000	98% (18%)	75% (13%)	44% (10%)
$80,000	100% (82%)	97% (55%)	79% (36%)
$100,000	100% (98%)	100% (81%)	91% (58%)
Arithmetic return	8% (6%)	8% (6%)	8% (6%)
Volatility drag	0.5%	1.1%	2.0%
Geometric return	7.5% (5.5%)	6.9% (4.9%)	6.0% (4.0%)

Source: Ioulia Tretiakova, PUR Investing Inc.

Expecting 8% is like having a fast base runner when compared with 6%. The probability of achieving the $200,000 target with 10% market volatility (standard deviation) is nearly certain for all starting capital amounts, but falls when volatility increases. At 20% market volatility, the probability falls to 44% with $60,000 in starting capital, for instance. The drop is the result of volatility drag, a mathematical return suppressant; the higher the level of market volatility, the lower the positive impact of compounding.

A 6% return assumption is like having a slower base runner. All probabilities for achieving $200,000 fall. In the case of a starting portfolio of $60,000, the fall is severe; to 10% at 20% volatility. Even starting with $100,000, 20% volatility provides only a 58% probability of success.

What’s going on?

Higher returns, like fast base runners, improve the probability of success. Starting with more capital is like starting on second or third base. But the impact of volatility is often overlooked. Low volatility is like starting with no outs. High volatility disproportionately increases the risk of falling short.

Conclusion

Advisors can improve the probability that investors achieve their targets regardless of starting capital or how late it is in their investment time horizon by doing two simple things:

• reducing the volatility of their portfolios by diversifying and using low volatility vehicles; and
• reducing stock exposure when market volatility is above average and increasing stock exposure when volatility is below average.

The probability of scoring runs, like capturing returns, improves when you know the odds. Today’s relatively low market volatility makes achieving goals more assured. However, clients should be informed that volatility can change, and saving more and starting immediately may be the only options.