When it comes to investing, it may be easy to think of investment risk as merely the chance that you may lose money. That is certainly part of it. But if that were the entirety of what investment risk entails, why would you want to undertake any risk at all? We prefer a more holistic perspective on risk: evaluating it as the likelihood that you won’t be able to meet your investment goals and the life goals that those investment goals support. Thinking of risk in this way shows both why some investments may be “too risky” for your goals or portfolio construction, but also why some may be “too safe” and not give you a chance for the kind of growth that will support your present and future financial plans. Risk might lose you money, but risk is also how you generate returns. You can’t have one without the other.
Why Focus on Risk? Understanding the Downside
A healthy aversion to losing money is a common trait among investors, and rightfully so. When your portfolio loses money, the amount required to recover from the loss significantly increases the more money you lose. Whereas a 10% drop requires an 11% gain to recover, a 50% loss requires a substantial 100% gain to recover! This is one reason we typically approach our investment choices with a “protect first, grow second” mentality. While the impact of major drawdowns may be less if you have a longer-term investment horizon, these scenarios reveal the importance of understanding both the potential downside and upside of every choice as you seek returns from your investments.
Figure 1: Gains Required to Recover From Loss
With regards to what makes an investment risky it can vary widely, especially when considered with what you are trying to accomplish. Your investments may rise or fall because of market conditions, corporate decisions, political or regulatory changes or international currency changes, just to name a few. If your portfolio is overexposed to illiquid investments you might have insufficient cash on hand when you need it most, or your portfolio could be overly dependent on the rise and fall of disproportionately large positions you hold.
No matter how you define or measure risk, there is no such thing as a risk-free investment. Even the seemingly “safest” investments, those extremely conservative choices with guaranteed returns, have risk because the risk of your portfolio not achieving your required rate of return is as real as the risk of losing money.
While Risk is Unavoidable, There is a Responsible Approach
Thankfully, we can use techniques and strategies in choosing investments that together can help you seek the greatest return for the risk that you are taking on by investing your wealth. A few of these are explained below:
We can use techniques and strategies in choosing investments that together can help you seek the greatest return for the risk that you are taking on by investing your wealth.
Notably, risk management is not all about protecting against losses. Evaluating these risk characteristics can also reveal where there are opportunities for return. Risk-adjusted returns measure the performance of a particular investment along with its volatility – or likelihood of rising and falling – over time. Volatility can be represented by values like standard deviation or beta that measure how high were the highs and how low were the lows of a particular investment over time. The risk-adjusted return is usually expressed as one of several types of ratio, each with its own name and unique formula but with the final result representing the same concept. Using risk-adjusted returns, we can compare investments with similar average returns that may have wildly different risk profiles to determine whether you are taking on an appropriate level of risk relative to potential returns.
In addition to historical data, future risk can also be assessed using forecasting models like Monte Carlo simulations and econometrics. Forecasting models allow analysts to factor in external influences like larger market conditions and global trends and run through a huge number of possible scenarios to see the likely outcomes. Even things like climate-related risk or risk related to social and political factors can now be incorporated in risk models.
Diversification, or allocating your portfolio across various investments and asset classes, is one of our best available tools for compensating for losses as it allows us to take advantage of the opportunity with which risk comes paired. An individual investment may be comparatively high risk but can make good investment sense as a portion of a larger portfolio, balanced by other, lower-risk investments. The entire portfolio’s overall risk is a more meaningful indicator of whether an investor’s goals are likely to be met and the general risk they’re taking on than the profile of any individual part of the whole. By having many eggs in many baskets, you may have many opportunities to make money, which balances out potential losses and grows your portfolio overall. We can protect against some risk while also taking the kind of healthy risk necessary to grow your assets and meet your goals.
Diversification also gives a portfolio a cushion against the risk that could blindside even the most well-informed investors. Behavioral finance expert, Morgan Housel, notes that “the biggest risk is what no one’s talking about, because if no one’s talking about it, no one is prepared for it.” While this is true in specific terms, having a broadly diversified portfolio focused first on asset protection can help protect against these so-called Black Swan events, that are nearly impossible to predict and far outside any typical expectations. Part of the advantage of diversification is that major events typically do not affect all asset classes and all market sectors equally, and those impacted can eventually recover provided you hold your positions long enough. Diversification provides many investors with peace of mind, allowing them to weather the market’s natural ups and downs without the temptation to sell at low points.
Finding the Best Risk Management Approach for You
Ultimately risk management is in service of your money doing its best to support your goals. First and foremost, meeting those goals requires protecting the wealth you already have. But taking on some risk is, as we’ve said, important and necessary, particularly in long-term financial planning where inflation and changes in the cost of living demand a minimum amount of growth simply to keep pace.
Ultimately risk management is in service of your money doing its best to support your goals.
Your advisor can help you to define your personal risk tolerance to guide your portfolio diversification and management decisions. Rather than focusing on technical questions about correlation, volatility or sector dynamics – your team will ask you questions about your lifestyle, preferences and reactions to some investment scenarios.
If you find you cannot reach your goals with a level of risk you feel comfortable with, you can either adjust your goal or take on more or less risk than you’d otherwise find ideal. Either scenario means your goal may not fit with the rest of your financial picture or that you need to prioritize your comfort and emotional wellbeing over a particular goal. Ultimately, risk tolerance, like financial planning in general, is deeply personal and sometimes emotional. The first priority is always to make your wealth work for you in a way with which you feel comfortable.
It’s impossible to predict all risk, and that is the reality of life and investing both. What we do know is that there will always be the possibility of the unexpected. However, with clearly identified goals, a bit of patience and a thoughtfully customized investment approach, we can prepare for the changes and chances in store.