Understanding Risk Is Critical
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 bonds 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 considerable 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 intent 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’ investments, have risk. You simply can’t escape the fact that nobody can predict with absolute certainty what an investment will be worth in the future.
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 sale. The second type of risk is 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 this 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.