Our Relationship with Investment Risk

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Is investing riskier than usual these days? In our experience, probably not. It just feels that way because of the constant bombardment of information. If there is such a thing as “normal” in this world of ours, risk is certainly built into the definition.

In Morningstar’s Quarterly Economic Commentary, Francisco Torralba, Ph.D., CFA described the [f]inancial markets as having lived in a heightened state of alert for the last two years. Markets had a boomerang first quarter. Quick retrenchment in January and early February gave way to a surge of optimism, which by the end of the trimester left investors more or less where they had started. Major drivers appeared to be oil prices, the renminbi, and central bank announcements. That risk premia would swing so dramatically in such a short period of time underscores … today’s market functioning.

Looking forward, whether it’s the recent destruction wrought by Canada’s Fort McMurray oil sands wildfire, a potential June “Brexit” from the European Union, or uncertainty surrounding this year’s US presidential election, there is plenty of risk to go around as we swing into another busy summer.

Let us revisit our investment risk relationship.

One: We Underestimate Risk.

It’s one thing when we imagine risk and its potential impact on our lives and our investments. It’s quite another when it really happens. In investing, underestimating risk can trick you into believing that you can tolerate far more of it than you actually can. Professor Rui Yao’s new research says that an initial positive experience of investing can lead some people to become overconfident.

Unfortunately, we can’t have it both ways. When the risk comes home to roost, if you panic and sell, it’s usually at a substantial loss. As financial columnist Chuck Jaffe has wryly observed: “[A] common mindset is ‘I can accept risks; I just don’t want to lose any money.’”

If you manage to hold firm despite your doubts, you may be okay in the end, but it might inflict far more emotional distress than is necessary for achieving your financial goals. Who needs that?

Two: We Overestimate Risk.

On the flip side, we also see investors overestimate risk and its sibling, uncertainty. We humans tend to be loss-averse (as first described by Nobel Laureate Daniel Kahneman and his colleague Amos Tversky), which means we’ll exaggerate and go well out of our way to avoid financial risk – even when it means sacrificing a greater likelihood for potential reward.

This summer already is destined to deliver plenty of uncertain outcomes. On the political front, there are stark contrasts found among the US presidential candidates. The “stay or go” uncertainty surrounding the June 23 Brexit vote could also impact financial markets in significant ways. Then there are the usual suspects, such as oil prices, continued Middle Eastern unrest and so on and so forth.

We don’t mean to downplay the real influence world events can have on your personal and financial well-being. But the markets tend to price in the ebbs and flows of unfolding news far more quickly than you can trade on them with consistent profitability. FinaMetrica has commented in a recent newsletter that investors have gone ‘off-script’ since 2008. They are giving equities the cold shoulder, despite strong gains that would usually attract them back. The scars of the great recession are deep.

So it’s a problem if you overestimate the lasting impact that this form of risk is expected to have on your individual investments.

Three: We Misunderstand Risk.

Especially when colored by our risk-averse, fight-or-flight instincts, it may seem important to react to current financial challenges by taking some sort of action – and fast.

Instead, once you’ve built a globally diversified, carefully allocated portfolio that reflects your personal goals and risk tolerances, you’re usually best off disregarding both the good and bad news that is unfolding in real time. This makes more sense when you understand the role that investment risks play in helping or hindering your overall investment experience. There are two, broadly different kinds of risks that investors face.

Avoidable Concentrated Risks – Concentrated risks are the kind we’ve been describing so far – the ones that wreak targeted havoc on particular stocks, bonds or sectors. In the science of investing, concentrated risks are considered avoidable. They still happen, but you can dramatically minimize their impact on your investments by diversifying your holdings widely and globally. That way, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with other, unaffected holdings.

Unavoidable Market Risks – At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (Its spending power may be eroded due to inflation, but that’s yet another kind of risk, for discussion on a different day.) Invest in the market and, presto, you’re exposed to systematic market-wide risk that cannot be “diversified away.”

Four: We Mistreat Risk.

It’s a delicate balance – neither overestimating the impact of avoidable, concentrated risks nor underestimating the far-reaching market risks involved. Either miscalculation can cause you to panic and sell out or sit out of the market, thus missing out on its long-term growth.

In contrast, those who stay invested when market risks are on the rise are better positioned to be compensated for their loyalty with higher expected returns.

In many ways, managing your investments is about managing the risks involved. Properly employed, investment risk can be a powerful ally in your quest to build personal wealth. Position it as a foe, and it can become an equally powerful force against you. Friend or foe, don’t be surprised when it routinely challenges your investment resolve.

Do you know your personal risk score? Respect and manage return-generating market risks. Avoid responding to toxic, concentrated risks. These are the steps toward a healthy relationship with financial risks and rewards. One of the ways we help you achieve your financial goals and objectives is by tending to an investment plan with the appropriate risk required but also with regard to your unique risk capacity and risk tolerance.

 

 

Disclaimer:
Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. Content should not be viewed as personalized investment advice or as an offer to buy or sell the securities mentioned. A professional advisor should be consulted before implementing any of the strategies presented.
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