One of the areas that I think is difficult for investors to truly get their arms around is risk. Specifically, the level of risk individuals are taking when they invest. One of the reasons for the fuzziness is that there are a number of ways to view risk. Warren Buffett views it as the likelihood of permanently losing his capital, or initial investment. Temporary losses are, well, temporary, and thus not really a concern for Buffett. The academics in the institutional investing universe – and most financial planning practitioners – think more in terms of volatility, or the frequency and magnitude of increases and decreases in the value of an investment portfolio.
Another issue with the notion of risk is that the appetite for it is a pretty intangible consideration for most individuals until after it has been tested by significant market downturns. That makes it tough to measure. Nonetheless, the typical financial planner will tend to take a new client through a series of hypothetical questions or scenarios to try to assess the client’s tolerance for bad things happening to their portfolios. When we as planners describe the risk of a given portfolio, or compare it to other portfolios, we often speak in terms of volatility. In other words, we are trying to understand how Mr. Investor would feel if his life savings went up or down by x%. I also like to highlight the frequency of actual historical losses across a given year for a similar portfolio. Unfortunately, our fancy graphs don’t necessarily get to the heart of what the specific risks are, or what we might do to deal with those risks. In our practice, we try to highlight the risks that are relevant to our clients’ portfolios, and then lay out what steps we take to try to dampen those threats.
The nature of investment risk
This is the first in a series of posts that are aimed at describing the types of risk that investments generally face. I’m not referring to specific risks we face now, so don’t look for my opinion on the market impact of Russia’s incursion into Crimea or whether or not Obamacare is the beginning of the end of the American empire. Rather, this will be a simple discussion of the kinds of risks that various investments face, and what might be done to mitigate some of those risks. To some degree, I’ll use my own terminology if I think it makes more sense than the language of the academics.
The next post in our series will address the Market Risk that impacts stocks. In later posts I’ll discuss the way Industry Risk and Business Risk affect stock market investments.
Beyond that, I’ll look at the way Interest Rate Risk, Inflation Risk and Credit Risk affect bonds. Lastly, I’ll cover some additional risks that exist when investing internationally.