The real risk management: income smoothing
Published: September 30, 2025
I recently came across a very smart definition of risk: Risk is the chance of an investment not delivering the return you expect from it.
I like this new definition because it’s different from the usual approaches. In Wall Street terms, risk is almost always equated with volatility. Frankly, I don’t consider that a serious metric for long-term investors. If you trade intraday or price options, it’s a critical variable, but for those of us who buy an asset with a plan to hold it for decades, the daily swings are mostly just noise.
The other definition often comes from those less experienced with investing, where risk simply means losing everything you have. While avoiding a total loss is certainly part of the picture, this view is still incomplete. It completely disregards the far more common and subtle risk of underperformance. If you invest in stocks, for example, your goal probably isn’t a 2% return. Achieving that, while not a loss, is still a risk that has materialized: the risk of your capital failing to do its job. This becomes especially problematic in a high-inflation environment like the one we just experienced over the last couple of years.
Why This Definition Changes Everything
First, it makes risk tangible, which helps with the psychology of investing. It’s not a vague feeling of danger; it’s a measurable probability. A financial plan can state there is a 15% chance of underperforming your goal, and that is a number you can work with.
Second, it clarifies that you have two levers to manage risk. If an asset has too high a chance of “underperforming your expected return,” you can either
- reduce your risk by buying a higher quality, more predictable asset
- simply reduce your return expectation to a more realistic level.
Risk becomes a manageable trade-off, not a scary monster.
Finally, it correctly reframes which assets are truly “risky.” In this model, holding cash for long-term goals becomes one of the riskiest things you can do. Unless your expected return is 0%, cash is almost guaranteed to underperform.
The Strategy: Income Smoothing
This brings us to the strategy for managing this kind of risk: income smoothing. This is the process of balancing out your investment income streams, perhaps even at the cost of some potential top-end returns, to create a more predictable and stable outcome.
You can do this by lowering your return expectations and buying safer assets within the same class: a property in a large, stable city instead of a more speculative bet, or a safe blue-chip stock instead of a small-cap biotech company.
But the more powerful method is to buy uncorrelated assets.
Diversification: The Only Free Lunch?
Diversification is not just about owning many things. If you buy shares in 10 different oil companies for €10 each, you are not much better protected than if you bought €100 worth of a single oil company. If the price of oil crashes, your entire portfolio suffers. This is because these assets are highly correlated, meaning they move together.
True diversification, and the key to income smoothing, is owning assets that are uncorrelated or have low correlation. Think of assets that thrive in different economic environments. The classic example is stocks and high-quality government bonds. Often, when fear is high and stocks fall, investors seek the safety of bonds, pushing their prices up. Other examples include real estate, which follows its own market cycles, or commodities like gold.
It is close to impossible that every asset class in the world is in decline at the same time. A well-diversified portfolio ensures that even if one part of your portfolio is having a bad quarter, other parts are likely stable or growing, smoothing out your overall return.
The Psychological Payoff
This strategy also provides a level of psychological safety, which becomes invaluable as you start managing a larger sum of assets. There is a well-documented psychological bias called loss aversion: loosing €10 from your wallet hurts much more than finding a same €10 on the street pleases you.
A volatile portfolio that swings wildly creates significant psychological stress and can lead to the biggest mistake an investor can make: panic selling at the bottom of a market crash.
A smoother, more stable portfolio helps protect you from your own worst instincts. For me, the feeling of checking my portfolio quarterly and seeing that, most of the time, the total value has grown is incredibly comforting. Seeing a relatively stable stream of income (around the same dividend every quarter, or the same rental payment every month) is far more reassuring than waiting for an eventual, uncertain lump sum. This is the great feeling that a well-designed pick of assets and a clear strategy will provide you.
Can Metis help you analyze your portfolio’s diversification and track your income streams?