Understand risk, and ourselves
What does investment risk mean to you?
We explore what is meant, and understood, by the concepts of risk and market volatility when it comes to investing.
Risk. One of the most important but oft misunderstood words in finance. Important, because investors should take an appropriate amount of risk for them, so we need to be clear about what exactly ‘it’ is. Misunderstood, because this clarity is seldom the case. Here we explore how investors should think about risk and their attitudes towards it.
What is risk?
When it comes to investing, many people see risk as a short-term concept and not about their long-term goals. The reasons for this are largely down to our psychology and the way we interpret information. For example, the financial markets often attract the attention of the mainstream media when volatility spikes and this helps perpetuate the sense that short-term fluctuations equals risk in investing. The fact that many who don’t follow markets will now have heard of GameStop is a case in point.
However, the investment industry has a hand in perpetuating this. We are frequently told, risk is volatility, defined by the standard deviation – a measure of the amount a value has differed from the average over time – of an investment over a period of time, commonly a year.
It's an old, old wooden ship
But if this is what we expend effort avoiding, we’re focusing on the wrong thing. A good analogy might be an urgent sea voyage where every minute counts. Going full engine into waves creates turbulence along the way that is unpleasant, but is not risky unless this turbulence increases the risk of a slow journey1. If your aim is a pleasant journey, then by all means take it slow; but if your chief aim is getting there on time, then you are better advised to invest in tablets for seasickness.
How should investors think about risk then?
Short-term investment fluctuations are distressing. But it is not risk for many investors. As individuals we are investing to achieve certain long-term goals, so risk should be defined as the chance that you may not reach these goals. To illustrate this difference, see the three dotted lines of different possible paths of investment returns in Figure 1. The bottom two are perfectly smooth, with no volatility, but end up with average, or negative returns respectively. The higher path offers high returns at the end of the investor’s time horizon, but is extremely volatile. Investors who represent ‘risk’ as volatility often weed out portfolios with good returns to avoid the temporary discomfort of turbulence. To get the best risk-adjusted returns we need to focus on the possible outcomes, not a smooth ride.
Think about holding money in cash. While there is no fluctuation in value of the capital (and often considered a riskless asset), ultra-low interest rates mean that you are all but guaranteed to lose the spending power over time. You would be hard pushed to argue that for someone whose wants to grow the spending power of their money, cash does not present a significant risk.
Why all the attitude?
This means to build a successful investment portfolio, it is fundamental to understand how you feel about the trade-off between the chance of greater returns and greater certainty of returns in the long term. It is your attitude towards this trade-off that defines your risk tolerance, and alongside what you want to achieve with your investments will determine the right mix of assets. Importantly, this requires us to make a distinction between the risk of reaching long-term goals and the natural gyrations of financial markets.
Keeping your cool: Composure
This is not to say that the path of your investment journey is not important. Our understanding of investing behaviour tells us that it is also important to understand how you are likely to react to the short-term fluctuations. We call this trait ‘composure’ and believe it should be considered alongside risk tolerance to help decide the right balance of assets and types of investments.
However, it can be difficult to untangle these different traits and in trying to ascertain an investor’s attitude to risk they are often confounded together, muddying the problem. This is why we developed our unique psychometric assessment tool, the Financial Personality Assessment, to help us understand your attitudes and give investment advice tailored to your personality.
1. Or, of course the ship sinks altogether, which could happen if your ship is badly constructed and unsuited to the voyage. In a portfolio context this can happen when your portfolio is not spread well across different asset types, geographies and sectors: any one investment can be sunk by events along the journey.
Things to consider
The value of investments can fall as well as rise. You may get back less than what you originally invested.
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