Investment Basics: What is Risk?
While it should be obvious that one of the primary goals of investing is to earn some kind of return on your money, an equally important, but often less obvious goal is to manage risk. In financial speak, we often use the word “volatility” to describe risk, but the truth is that “volatility” means very little to the average person and doesn’t begin to cover all the different types of risk that are out there. In order to be intelligent investors, it’s important that we take the time to understand the various types of risk out there and the best ways to counter them. Since there are many types of risk, we’re going to break this article up into a series covering several different important types of risk, the first of which is hopefully the most commonly feared – losing money.
In a previous post, we mentioned the importance of understanding the relationship between price and value and how any great company can become a poor investment at too high a price. The relationship between risk and value is similar. People often think of risk as a side effect of seeking return, and it certainly is, but left unchecked, taking too much risk can seriously threaten your financial security. One common misperception of risk is that taking more risk will guarantee a higher return. A more accurate statement would be that taking more risk should offer the potential for a higher return. When most people think of risk, they envision the following graph in their mind:
The truth is, the graph should actually look something like the following:
As risk increases, the potential for return increases, but the potential to lose money also increases. Why is this? The inherent relationship between risk and return should be thought of in terms of the investor being compensated for taking risk. When you invest in a company, the return you get is, in effect, compensation that you are receiving in return for letting the company borrow your money. The more likely the company is to lose all of your money the more it must pay you to borrow your money. That’s why smaller companies that are less stable must pay you more to borrow your money (they must return more) because they are more likely to go bankrupt and lose it all (they are riskier).
If I were to ask my clients, “what do you fear most when it comes to investing?” the answer I would expect to receive from pretty much everyone would be that they fear losing their hard-earned money. If I were to go to an investment conference on risk, we would likely discuss terms like “volatility” and “standard deviation,” but that means nothing to my clients. As famed investor, Howard Marx, puts it: “I’ve never heard anyone at Oaktree – or anywhere else, for that matter – say, “I won’t buy it, because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.” Of course, the relationship between loss of money and “volatility” is cemented when you sell during a downturn, thereby locking in the loss.
This brings me to my first takeaway: know your time frame and your personal propensity for risk-taking. If you need money soon, don’t invest your savings in something risky. If you can’t handle seeing your investments periodically drop, don’t invest in the types of assets that are known to do that. Even if you pick a great company, there is still the possibility that the market as a whole may be choppy like it has been recently, and you never want to be in a position of having to sell. Having to sell is one of the quickest ways you will find yourself locking in low prices and losing money.
Secondly, don’t assume that just because something is really risky, that it will produce incredible returns. Sometimes, a risky investment is simply that – a risky investment. The relationship between value and risk is important for a reason. You should always do your homework and make sure that taking the extra risk can be justified. Ask yourself "what do I expect to happen that will justify taking this risk, and how certain am I of that happening?" Just like shopping for deals at the grocery store, you should look for great deals when investing. If you’d like to learn more about risk taking or get a better idea of your personal propensity for risk-taking, feel free to contact one of our experts. We’re happy to share our insights.
Marks, Howard. “The Most Important Thing: Uncommon Sense for the Thoughtful Investor.” Columbia Business School Publishing. 2011. (pages 33 and 34).