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A Short Primer On Risk

Understanding Risk Is Important

Risk is one of the most difficult concepts for amateur investors to master (I use amateur not in a pejorative sense, but as compared to professional investors.)  Part of the reason for this is that investment risk is often counter-intuitive.  Take treasury bonds for example.  Treasury bonds are often described as “riskless” investments.  The theory is that the U.S. government is unlikely to default on its obligation to bondholders, and therefore your money is always safe in treasury bonds because they’re backed by the full faith and credit of the USA.  This statement is true, but it doesn’t necessarily follow that investing in treasury bonds is free from risk.  Treasury bonds trade on the open market, and the prices of treasury bonds fluctuate, just as the prices of stocks fluctuate.  If you invest in treasury bonds at a time when interest rates are historically low, you are in fact exposing yourself to above-average risk.

Bond lovers will counter with the argument that if you hold your treasury bond until it matures, you are guaranteed to receive 100% of the face value of the bond, and therefore they are truly riskless.  My answer to this argument is that very few investors actually buy treasury bonds with the intention of holding them to maturity.  Most investors sell their bonds before they mature, and this exposes them to the risk of selling them for less than their purchase price.  The point is that all investments, including so-called ‘riskless’ treasury bonds, have risk.  You simply can’t escape the fact that nobody can predict with absolute certainty what an investment will be worth when it comes time to sell.

How Much Risk Are You Taking?

Many investors use what I call an Ad Hoc Stock Picking approach.  What I mean by this is that they wait until they ‘feel good’ about their economic circumstances, and then they start picking stocks based on a combination of tips, recommendations, and hunches from all kinds of sources.  It’s called Ad Hoc because there is no unifying theme or context for their choices.  They end up with a collection of stocks that may or may not be appropriate for their circumstances.  And by not considering the prospects for growth in the economy, they risk being too heavily concentrated in stocks at the wrong time.  We advocate a balanced approach to stock picking, which dramatically reduces overall risk while not sacrificing the fun and excitement of ‘playing’ the stockmarket.

Types of Risk

There are two main types of investment risk.  The first is the risk that the market price of the investment will decline and the investor will take a loss at the time of the sale.  The second type of risk is the loss of purchasing power.  Inflation averages about 4% per year over the long term.  If your investment produces a rate of return that is less than the inflation rate, which is often the case with ‘safe’ investments like treasury bonds, then you will find yourself in a situation where you made a profit on your investment but lost purchasing  power.  Would you be satisfied with that outcome?

The Answer

In order to manage these dual risks – price risk and purchasing power risk – an investor has to create an investment portfolio that includes components that will provide some protection against both market downturns and inflation surges.  The only way to do this is with a balanced approach that includes many different types of assets, like stocks, bonds, real estate, gold, hedge funds, private equity, volatility, and others.  The more asset classes you have in your portfolio, the less overall risk you take.  Risk is not a bad thing.  In fact, it’s because of risk that investors are rewarded with returns that are higher than the rate of inflation.  If you have a well-diversified portfolio, you should be seeking risk, not running from it.  Risk is the source of superior investment returns.  But risk must be properly understood, and managed.  Ad Hoc investing ignores this calculation of risk, and because of this, returns are usually disappointing.

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