Welcome to the first in a new series of articles in which we are going to be looking at the fundamentals of investing. We’re starting with one of the most important, and also the most difficult, questions of all: How much risk should you take?
Ask an economist to define risk when it comes to investment and they will most likely reply that it depends. Of course, there are complex mathematical models that attempt to quantify risks, but these on their own are never likely to be enough.
Risk related to any one investment often comes down to a whole bunch of other factors, like what is happening in the rest of your portfolio or what your consumption needs are at any one time or what’s happening with your job and income.
Risk and volatility are not the same thing
Sometimes you will hear risk being defined in terms of volatility, or the degree to which an individual investment goes up and down in price. But this an over-simplification and doesn’t take into account all the individual elements that come into play.
For instance, it means very little that your stock portfolio is gyrating wildly from day to day if your investment horizon is 20 years or more. Ultimately, what you are worried about is a permanent loss of capital. In contrast, if you’re three months away from retirement and the market drops 40%, that’s a risk you should be concerned about.
Ultimately, risk is not a number but a scenario — your money is lost, you don’t have enough to retire on, you can’t reach a specific goal, you can’t get easy access to your money, or you’re too exposed to a single stock, sector, country or currency.
In any case, volatility on its own tells you nothing. You might have two individual stocks with similar levels of volatility. But if one of them has poor returns at a time when you need the money or you’re out of a job, then it’s riskier for you.
Risk is not the same as uncertainty either
Another common misconception is mistaking risks for uncertainty. In both cases, no one can say for sure what is going to happen. But in the case of risk, we at least have a sense of the probabilities. If you flip a coin, for instance, you know there is a 50% chance of it coming up tails. Of course, you might throw heads ten times in a row, but the point is you know there are only two possible outcomes. You can judge the odds.
With uncertainty, you can’t model it. A rare event comes out of left-field, confounding all expectations. A metaphor often used here is a ‘black swan’ event, popularised in a 2007 book by Nassim Nicholas Taleb. Think of the 9/11 attacks or the global financial crisis.
Not taking risk is a risk in itself
The other frequently overlooked idea is that not taking any risks at all can be a risk in itself. For instance, by being overly defensive in your portfolio there’s a risk you may not have enough to retire on. Some level of risk is necessary because the flipside is the possibility of return. The key question is how much risk you can live with.
Finally, in assessing risk it’s important to distinguish systematic risk from non-systematic risk. The first is something you can’t avoid. It goes with the territory. For instance, shares are considered riskier than bonds and for that reason they offer a higher expected return.
Non-systematic risk you can manage. If your entire portfolio was in banking stocks ahead of the global financial crisis, that was concentration risk — a type of non-systematic risk. You could have managed that by diversifying across different sectors.
There are lots of other types of risk, as well. Liquidity risk refers to how easily you can access your money. Credit risk refers to the possibility of a bond issuer defaulting. Inflation risk relates to a generalised rise in prices eating up the value of your investment.
The overall rule is that you want to take risks that are related to a reward. In general, markets reward risk over the long term, providing you are sufficiently diversified and disciplined and pay attention to factors within your control, such as costs and taxes.
Periods of discomfort are guaranteed
So, back to the question we asked at the start: How much risk should you take? Unfortunately, we are going to have to call on that economist answer again: it depends. It depends on you and your circumstances. What are your goals? What risks can you live with? How many risks do you need to take?
Ultimately, there isn’t one right answer. What we do know is there will inevitably be periods where you feel uncomfortable. That’s OK. Depending on your horizon, and assuming you are sufficiently diversified, you may be able to ride out that out.
Remember, these sorts of questions are complex, and it’s vital that you get them right. This series of articles is not intended as investment advice. TEBI always recommends working with a competent financial adviser with your best interests at heart.
Next time: How predictable are movements in stock prices?
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