Risk is the greatest external threat investors face. Failure to manage risk can keep you from achieving your goals, can result in loss of principal, and can cause stress and a host of other problems. It is impossible to understand investing without understanding risk.
If you ask a financial advisor or other financial professional what risk is, they’ll generally tell you it is volatility, or short-term fluctuations in the market. If you ask most investors who are not professionals what risk is, they’ll generally tell you it is the likelihood of losing some or all of their investment.
It’s no wonder people are confused. The experts are talking about one thing; the people think they are talking about something else. And the one the people care about — the chance of losing some or all of your investment — is one that has meaning in the real world.
The two are connected, but not the same. And there’s more: Risk is more than volatility; it’s more than the chance of losing money. Here’s what every investor needs to know about risk.
Risk vs. Investment Risk
We face risk every day. There’s risk in walking, there’s risk in driving. We face the risk of getting hurt or injured every single day. Hopefully we don’t get caught up in that; hopefully we don’t take excessive risk, and we don’t dwell on everything that could go wrong. But risk is a real part of life; there is no way to live life without risk.
There’s also no way to have money without risk. It’s a different kind of risk, however, and not just the risk of fluctuations in the market or of losing some money. If we are too conservative with our investments, if we minimize the chance of losing money, we probably won’t be able to meet our goals. If, for example, we are very conservative with our retirement investments, we will probably not have a very comfortable retirement. In order to achieve financial goals, we need to take some risk.
Risk Is Contextual
Goals give context and meaning to risk. There is no way to assess risk absent a timeframe and purpose, two things that help define a goal.
For example, if you have an objective to make as much money as possible, the objective is meaningless without a timeframe. The way to invest your money to have as much as possible tomorrow or next month is different from how to invest it to have as much in five years, which is different from how to invest it to have as much in 20 years.
Purpose tells you how important the goal is.
You might consider how to invest for retirement differently than how to invest for your children’s education, based on your feelings about the goals. Context matters. Timeframe matters. When it comes to risk, goals matter.
Risk Is a Spectrum
Risk is not a discrete thing that is either there or not; it exists as a spectrum. What are generally considered low-risk investments carry the burden of not doing much to help you achieve long-term goals. If you invest in low-risk long-term investments, you exchange the risk of loss or of fluctuations in principal for an increased risk of not attaining your goals. Risk is indeed a double-edged sword; you cannot have zero risk.
Risk-free return is a theoretical concept of an investment that poses no risk. Professionals look at the spread an investment might produce over this theoretical risk-free return to assess the risk versus reward of the higher return. The idea of risk free is, however, theoretical. Often a return such as from a short-term government instrument is used as a proxy for a risk-free return, but the only risk being considered is that of loss of principal, not of failure to achieve long-term goals.
Volatility vs. Chance of Loss
When an advisor tells you that volatility is risk, they’re often only talking about the downward part of volatility. Volatility, after all, is short-term price fluctuations and involves increases as well as decreases in price. An asset that only falls in price is not volatile; an asset that only gains in price is not volatile; it must do both or it is not volatile. Advisors don’t call short-term price increases “risk”; they call that “return.” They’re talking only about the downside, which is a lot closer to what investors are talking about: the chance of losing money.
And in the long term, volatility becomes less important, as it produces less effect. The chance of volatility producing a negative return, short term, is fairly high; the chance of volatility producing a negative return, long term, is far lower.
In the short term, volatility and chance of loss of some of the investment are very similar. In the long term, they’re not.
Managing Investment Risk
There are several ways to manage investment risk. The first thing we need to do is assess risk in the context of what we’re trying to achieve. The risk we can accept in our emergency fund is not the same risk we can accept with our retirement investments, and we cannot manage them the same way.
A primary way to manage risk is through diversification.
We need investments that behave differently at different times, providing a sort of offset to each other’s risk. A diversified portfolio should have lower risk overall than that of its most volatile investments, but will have higher risk overall than that of its least volatile investments.
Because goals drive risk, and timeframe drives goals, risk is not static; it changes as we get closer to the goal. This is also goal dependent. Some goals occur at a point in time, such as for a house down payment, or over a short period of time, such as for college education. Other goals are spread over many years, such as retirement; when we’re at or near the goal, it will need to be managed both as a short-term goal, for the next couple years’ expenses, and as a long-term goal, for those funds needed later in retirement.
The Bottom Line
Risk is manageable. Most investors invest to achieve goals, and managing risk can help them to achieve those goals. This can be done by selecting appropriate investments, ones that have enough risk to provide a positive long-term real return, without having so much risk so as to be speculative. Risk is contextual and needs to be considered in light of the goals the investment supports.
We often see people panic when markets decline. This panic is indicative of either not understanding the risks the investor has taken on, or perhaps of not investing for goals. If you’re investing for retirement, for example, and retirement is 20 years away, it is easy to see how a tough market is not a direct threat to your goal. However, if you have no goal, the default is to see risk as loss of money — and a tough market will always be a threat. If the investor is looking at long-term investments through a short-term lens, they are not going to like what they see.
The financially literate thing to do is to understand the risks, understand how the investments help you achieve your goals, and not lose sleep over what you can’t control. Understanding risk is key to financial success.