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Risk is a key aspect of investing; any conversation about returns or performance is meaningless without including the risks involved. The problem for new investors, however, is calculating where the risk really lies and what separates low risk and high risk opportunities.
Considering how central risk is to investments, many new investors show naivety in believing that it can be well-defined and quantifiable. Sadly, it is not so straight forward. There is still no overall consensus of what “risk” means exactly or how it can be measured.
Experts regularly like to measure volatility as a gauge of risk. In some ways this is very logical. Volatility measures how much a given number can vary over time. The broader the range of possible outcomes, the more likely some of these outcomes will be bad. It is also helpful that volatility is comparatively easy to measure.
Sadly, however, volatility alone is not a perfect measure of risk. While being true that more volatile stocks or bonds will expose the owner to a wider range of possible outcomes, it does not always affect the likelihood of such outcomes. Often, volatility can likened to turbulence a passenger experiences on an airplane. Somewhat stressful, but does not indicate the likelihood of a crash.
A better way to view risk is assessment of the possibility or probability of an asset experiencing a permanent loss of value or below-expectation performance. When an investor buys an asset with an expectation of a 10% return, the chance that this return will be below 10% is the risk of the investment. Under-performance relative to an index is not necessarily risk. If an investor buys an asset with the expectation that it will return 7% and it returns 8%, the fact that the S&P 500 returned 10% is largely irrelevant.
High-risk investments are when there is either (1) a high percentage chance of loss of capital or under-performance, or (2) a relatively high chance of a devastating loss.
If you were told there’s a 50/50 chance that your investment will earn your expected return, you might think this sounds quite risky. However, if you were told that there is a 95% percent chance that the investment will not earn your expected return, most will agree that it is risky.
This second scenario is what many investors fail to consider. For ease of explanation, take the example car and airplane crashes: a National Safety Council analysis from 2019 told us that a person’s lifetime odds of dying from any accident has risen to 1/25, an increase from odds of 1/30 in 2004. In comparison, the odds of dying in a car crash are only 1/102, while the odds of dying in a plane crash are far smaller, only 1/205,552.
What is meant by this example is that investors should consider both the likelihood of something and the magnitude of how bad outcome could be.
The very concept of low-risk investing is that there is less at stake. This can be either the amount invested, or the significance of the investment to the portfolio. On the flip-side, there is also less to gain in terms of potential returns.
Low-risk investing means both protecting against the chance of any losses, but it also making sure that any potential losses will not be devastating.
If investors are able to accept that investment risk is defined by a loss of capital and/or under-performance relative to expectations, it makes defining low-risk and high-risk investments substantially easier.
It is also important to consider the benefits that diversification can have on the risk of an investment portfolio. Dividend-paying stocks of major Fortune 100 corporations are usually quite safe. Investors can often expect to earn mid-to-high single-digit returns over the course of several years.
Despite this, there is always some risk that an individual company will fail. Companies such as Eastman Kodak and Woolworths are famous examples that were once successful but were eventually liquidated.
If an investor places all of their money in one stock, the odds of a bad event happening may still be low, but the potential severity is quite high. Holding a portfolio of around 10 stocks, however, not only reduces the risk of portfolio under-performance, the size of potential gains for an overall portfolio also declines.
Investors need to show a willingness to be flexible. For instance, diversification is an important part of risk. Holding a portfolio of investments that all have low risk, but all have an equal risk, can also be dangerous. Referring back to the airplane example, the odds of an individual airplane crashing at is roughly 1/5,400,000, however most large airlines have (or will) experience a crash of some sort.
Holding a portfolio of low-risk Treasury bonds may seem like very low-risk investing, but they all share the same risks; the occurrence of a very low-probability event (such as a U.S. government default) would be devastating.
Investors also need to include factors such as time-span, expected returns, and knowledge when thinking about risk. Generally speaking, the longer an investor can wait, the more likely that an investor will achieve their expected returns.
There is a strong correlation between risk and return, where investors expecting huge returns need to accept a much larger risk of under-performance. Knowledge is also vital, not only in identifying investments that are most likely to achieve their expected return (or better), but also miscalculating the likelihood and magnitude of what can go wrong.
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