Understanding Investment Risk, Part One
By Gary Silverman, CFP®
When it comes to investing, I think risk is one of the most important variables to consider. I spent about 20% of my book covering the topic, and I’ll spend a few weeks covering it here, as well.
Risk taking is invigorating to those who plunge down white water rapids, soar through the skies strapped to a hang glider, or descend into the earth while spelunking. For most, those feats bring not exhilaration, but fear. The same can be said when it comes to investing. Ask most investors about risk and you'll hear that it's something they want to avoid.
But what is risk? Technically, risk is simply the variation you see compared to the expected value. Another word we might use is volatility. And it’s the down part of that volatility that investors fear. To help alleviate the fear, you, as an investor, need to do three things:
First is to realize that risk is an essential part of any investment. Every investment decision, including stuffing cash in your mattress, involves risk. Your expected value is that when you come back home, the money is in your mattress. Variables include your dog eating the money, your kids spending the money, or a fire destroying the money. All are variables to your expectations.
The key is to understand what risks you are taking. That way you won’t back yourself off a cliff trying to get away from a lesser danger.
Second, investors seeking greater investment rewards must be willing to accept greater risk.
As you might expect, by lowering the risk of a portfolio, we generally also lower the anticipated long-term returns. This can be a good trade-off. Why? Because in time of market turmoil, investors will do stupid things if their portfolios drop too far for too long.
In both the tech-bubble burst at the turn of the century and the credit crisis that followed, markets crashed. In both instances investors could stand only so much and many sold after the massive declines. If they had been able to hold on, they would have seen their portfolios eventually recover and grow. But fear overrode sense and their temporary losses became permanent.
By limiting a portfolio’s risk in line with your ability to tolerate it, you can reduce or eliminate the chance that you will “freak” and sell out during a market bottom. Preventing that possibility is well worth a slight reduction in expected returns.
Third, the risks an investor faces can vary depending on how long an investor has to achieve her or his investment goals.
There are some interesting ramifications to this. Most investment professionals will tell you that time will reduce risk. But quite a few economics professors will tell you that the longer your time period the worse your risk becomes.
Which of them is right? We’ll find out next week.
This article was published in the Wichita Falls Times Record News on February 12, 2017.
Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.