The Two Sides Of Investment Risk

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Investment RiskThere are many different types of investment risk. Most of the time the market does a good job interpreting those risks.

But not always.

As an investor, its your job to keep those investment risks low and decide when the market is right or if it’s wrong.

What is Investment Risk?

Investment risk in the simplest of terms can be defined as a permanent loss or a lower than expected return.

The permanent loss is easy enough. You invest in a stock. That stock drops in price and stays down indefinitely. Or until you sell, making the risk of loss permanent.

As for the lower than expected return, it’s no different from buying an index fund, say an S&P 500 fund that never lives up to its name. If this were in your retirement account, your account balance would fall far short of your expected return at your retirement party. You’d be kicking yourself for choosing a sub par index fund and missing out on a higher return.

Risk of Loss

There are two types of losses you deal with: paper losses and permanent losses. A paper loss is nothing more than one of two accounting results we get from tracking our investments. The other result is a paper gain.

It’s nothing more than tracking the score in a baseball game. It tells us which investments are winning and losing at that particular moment…nothing more, nothing less. But the game is far from over. Unless we let our emotions get in the way.

When it comes to money, our first reaction is usually the wrong one. We fail to take into account our investment time horizon, the real risk involved, and whether it has any bearing on our investment goals. It’s these mistakes, behavior risks, that consistently drive lower than expected returns.

More often than not, it shouldn’t be a concern for a long-term investor. These short-term swings in price happen all the time. It’s how the stock market works in the short-term. Two people get together and agree on a price. Some days the price is high, other days its low. This is the volatility you deal with daily.

A Note On Volatility

People often mistake volatility for risk. Volatility, if anything, is just a measure of opportunity. A highly volatile stock offers more opportunities to buy low. A less volatile stock offers fewer. The volatility is the effect of perceived or real risks. Because sometimes those two people get together and agree on a price so outrageous, it’s irrational. Which leads to opportunities.

Reward

At any given time the financial markets are made up of thousands of possible risks and opportunities.

The Fiscal Cliff, the Fed policy, higher taxes, government debt are all events that may or may not be risks. Either way prices are affected by this. But should that risk prove false or be waylaid by another action, these price changes quickly become opportunities. If it wasn’t some contrived risk already.

A diligent investor pays attention to all the events. You won’t have to react to every new risk that presents itself and only the better opportunities are worth checking out. Much of your decisions will be based on your time horizon. In the end, your asset allocation will be built and adjusted to manage risk.

Too many investors still follow the age-old theory that the more risk you take, the greater the potential reward. This works great for a casino business model. This jackpot theory pays the house well. But has no place in common sense investing.

As investors we should be constantly looking to reduce investment risk while trying to achieve a greater reward. You just need to take advantage of the opportunities volatility provides without letting your emotions get in the way.

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Comments

  1. says

    I’m glad someone else shared their explanation of risk and volatility. I invest almost exclusively in leveraged ETFs and most people think that I am crazy. But I tell them they are volatile and not necessarily risky. They assume that those two components are one in the same. I explain volatility as driving down the highway at 100 mph and risk as driving down the highway at 100 mph IN TRAFFIC

    • Jon says

      That’s a good way to look at it. It’s certainly true for leveraged ETFs which I’ve never been able to wrap my head around. My long term focus can’t grasp that daily trade.

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