We all know investing entails some degree of risk, but what do we really mean when we talk about investment risk, and how does that compare with the risks we take in our daily non-investing lives? When we think about risk in our to day to day lives it can have several meanings. Many of us may think about risk in terms of a negative outcome to a given event or it might simply be that an outcome is unknown. These day to day views of risk are both very applicable when it comes to investment risk, but let’s take a deeper look at that.
The most straight forward comparison is risk being an unknown outcome. This doesn’t even have to mean the outcome will be negative, just unknown. Think about the things where this applies to in our non-investing life. Maybe you try a new recipe, get a new hairstyle, ask someone on a date, ask your boss for a raise or some other thing that puts you out of your comfort zone or has you trying something new. If it goes well, you get a nice win. If it goes bad, you may not like it, but the downside is generally limited, and you will recover quickly.
Now, let’s think about risk that can result in a truly negative outcome. Risky behaviors and activities can possibly result in a big payoff, but the downside can be severe if it doesn’t work out. Watching the downhill skiing event last night in the Olympics made me think of the comparison. They were competing for a gold medal, the height of their profession, but a slip of a ski could cause a nasty crash resulting in a concussion, torn ligaments or even broken bones. Taking that a step further, think about skydiving. A successful jump can be a once in a lifetime thrill ride (at least it was for me) but if it goes bad the consequences are obviously dire.
When it comes to risk in investing there is always risk of the unknown. About the only "risk-free" assets are cash and Treasury Bonds. Even these “risk-free” assets come with some risk. While the face value of cash is safe it can lose real value with inflation. Treasury bonds are considered safe because we can count on the US Government to pay the stated interest but fluctuating interest rates can cause the value of the bond itself to go up or down.
When it comes to investing, we take a calculated risk when we purchase an asset. We can look at historical data and trends to tell us that stocks will return an average of 8-10% a year and bonds 3-5%. We know that the actual annual returns will vary though. Some years will be better, some will be worse. That is our unknown. We never know from year to year exactly what we will get. Depending on where you are at with your investing lifecycle these year to year fluctuations might be no big deal or they could have a very detrimental impact.
This is a concept called sequence of return risk. A 30 year old investor has plenty of time to ride out these year to year unknown returns and can rely on the long term averages to get them where they need. A 20% market downturn next year likely doesn’t submarine their long term goals as there is plenty of time to recover. On the other hand, for someone who is one year away from retiring a 20% downturn in the market could be devastating. With proper financial planning though you mitigate this risk by adjusting your portfolio so a 20% market downturn doesn’t have as big of an impact on your personal situation.
If your portfolio has the appropriate amount of risk, then the risk of unknown returns is hopefully similar to that of the minor risks you take in life. There might be a short term unpleasant impact but it shouldn’t really hurt you in the long run.
We can see some parallels between the smaller scale risks we take in our life and investing. But what about the big negative outcomes. Usually, when people have big concerns with investing it is about losing all of their money, the equivalent of skydiving gone bad. I call this absolute risk, the risk of losing your money. The truth is it is very, very rare to lose all of your money on an investment. There are specific investments such as options where this can happen but the vast majority of investing is done buying individual stocks, mutual funds and ETF’s. The truth is these hardly ever go to zero. Enron is a classic example, and more recently Sears, but with Sears it was a slow death that was very easy to see coming.
In the 2000’s we have had multiple instances where the market has taken a big hit. The dot com crash of the early 2000’s, the financial crisis of 2007-2009, the initial impact of Covid in early 2020 and, most recently, the tech correction of late 2021-early 2022. In all of these cases, broader markets fell at least 20% and as much as 40%, while individual stocks or funds may have been down by as much as 75%. For instance, a bank stock like Wells Fargo was down 75% from September 2008 to March 2009; Paypal is down almost 60% since September 2021, and everyone’s favorite Covid exercise fad, Peloton, is down over 75% in the past year.
If you have suffered these types of losses, it probably feels like the equivalent of that bad downhill skiing wipeout. It’s not quite like the parachute failed to open but you are bloodied and bruised. You can recover with time, but it might take a while. Again, though with proper portfolio allocation these losses won’t hurt nearly that bad. Take, what has been happening in the market the last few months. Certain high flying companies in the tech sector have seen huge drops, like the one I mentioned for Paypal. Proper portfolio allocation and diversification results in a portfolio that is spread out among many different areas. To that point, the S&P 500, is down just 7% since the first of the year, XLF (the financial sector ETF) is up 2% year to date, and XLE (the energy sector ETF) is up 19% so far in 2022. Having a diversified portfolio can go a long way to reduce the pain that one part of the market is suffering.
The primary way we measure risk with investments is volatility. Another way to think about this is the unpredictability of the investment returns. For instance, investment A has returned 30% over the past 5 years and if the annual returns are all in the range of 2-8% there is very little volatility. Investment B has returned 60% over the past five years but the annual returns range from -20% to 40%. This is deemed a much riskier investment even though the overall returns are higher. This is because we have much less confidence how that investment will perform year to year.
This takes us back to our sequence of return risk. As we get closer to needing that money, we need to reduce the risk of the portfolio. There is a relatively easy way to see how volatile an individual investment is. By using a tool like Yahoo Finance, Morningstar, or any other brokerage site you can see the details of an individual investment like this image below. In the risk section, you will find a value for standard deviation. Remember your stats class from years ago? Here is a real world use of it. The lower the standard deviation, the less volatile the returns.
Let’s be very clear. There is risk with investing. You can lose some of your money and you don’t know what your returns will be from year to year. But, by having a well diversified, risk appropriate portfolio you can enjoy the benefit of long term returns and avoid the parachute not opening.