Risk Isn't What You Think

Here is the article, rewritten in the appropriate voice.

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The public framework, borrowed from academia, defines risk as volatility—the statistical measure of how much an asset’s price fluctuates. This is a mathematical convenience. It allows for neat, pre-packaged products and “risk scores,” but it is a poor proxy for the dangers an investor actually faces.

For permanent capital like endowments, risk is not volatility. It is not the “bumpiness of the ride.”

Risk, in our world, is defined by two factors:

1. The permanent loss of capital.
2. The failure to meet the portfolio’s long-term objective.

This distinction is the philosophical cornerstone of the endowment model. Until you adopt this definition, the institutional toolkit will never make sense.

The Flaw in the “Volatility” Model

The problem with defining risk as volatility is that it misdiagnoses the true concentration of a portfolio.

The 60/40 portfolio is the primary example. On paper, it is sold as “balanced” because 60% of the dollars are in stocks and 40% are in bonds.

In an institutional investment office, we do not allocate by dollars; we allocate by risk contribution. We analyze what job each asset is doing and, more importantly, what risk it is contributing. When we apply this framework, the 60/40’s “balance” is revealed to be an illusion.

Equities are far more volatile than high-quality bonds. As a result, that 60% dollar allocation to stocks does not contribute 60% of the portfolio’s risk. It contributes over 90% of the portfolio’s total volatility.

A 60/40 portfolio is not a diversified portfolio. It is a 90/10 risk portfolio. It is a leveraged bet on the equity risk premium, and its fate is almost entirely tied to the direction of the stock market. The retail definition of risk (allocating by dollars) obscures this fact. The institutional definition (allocating by risk) exposes it immediately.

The Real Dangers: What an Endowment Fears

If my committee and I do not focus on short-term volatility, what are the risks that govern our decisions? We are focused entirely on structural, long-term failures.

1. Mandate Risk

My primary risk is not a bear market. It is the failure to meet our mandate.

An endowment’s portfolio is engineered to solve a specific problem: it must fund a Spending Rate (e.g., 5.0% for the university’s budget) and grow by the rate of Inflation (e.g., 2.5%) to preserve its purchasing power for future generations.

This creates a non-negotiable hurdle rate.

Required Nominal Return = Spending Rate (5.0%) + Target Inflation (2.5%) + Investment Costs (0.5%) = 8.0%

This 8.0% is the true benchmark for risk. My greatest danger is the long-term probability that my portfolio will fail to clear this 8.0% hurdle.

By this definition, a “safe” portfolio of cash and short-term bonds yielding 4% is the riskiest portfolio imaginable. It is a 100% statistical certainty for failure. It guarantees we will permanently destroy the endowment’s purchasing power.

This is why endowments are compelled to own high-growth, “volatile” assets like private equity and venture capital. We are not “risk-seeking.” We are mandate-driven. The risk of not compounding at our hurdle rate is the one risk we cannot accept.

2. Liquidity Risk (The Real Mismatch)

The public is taught that illiquidity—the inability to sell an asset today—is a risk to be avoided. For permanent capital, this is backwards.

The real danger is not illiquidity; it is being a forced seller.

The investor who must sell stocks in a 2008-style crash to meet a short-term cash need is the one who experiences a permanent loss of capital. The investor who is not forced to sell is merely experiencing temporary volatility.

Institutions re-frame this entire concept.

• The public is taught that liquidity is an asset to be held.
• Institutions know that liquidity is a cost, and they view illiquidity as a structural premium to be harvested.

We willingly lock up capital for 7-10 years because we are paid an “illiquidity premium” for providing patient capital to markets where competition is lower. Our greatest competitive advantage is our long-term liability structure, which gives us permission to invest in these long-term assets and harvest those returns. The true risk is a funding mismatch—holding long-term assets against short-term liabilities. We engineer our portfolio to do the opposite.

A New Framework

The first step in adopting an institutional framework is to discard the retail definition of risk.

You must stop asking, “How volatile is my portfolio?” You must begin asking, “What is the probability of my portfolio failing to achieve its objective?”

When you make this shift, the logic of the endowment model becomes clear. You stop confusing “safe” with “low volatility” and start to see that the real risk is the failure to grow.