Risk, what exactly is it? Why take it?

Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

One common theme in many of Garth’s posting is that the real risk for people, especially baby boomer is not stock market risk but the risk of outliving one’s money. Therefore one must invest to mitigate that risk and can do so by creating a diversified portfolio that invests in financial assets that will grow and earn at least 6% return, all with minimal risk. People should not be afraid of the risks associated with investing in stocks & bonds, especially those with long time horizon.
 
So what exact is risk as related to stock & bond investing? Is it important?

Risk in financial industry is actually a very complicated subject with volumes upon volumes of research papers and horrendously looking mathematical formulas devoted to measuring and quantify it, optimizing, and making money from it. There are also many kinds of risk including market risk, liquidity risk, counterparty risk, and credit risk to name just a few.

The topic of risk will almost come up one way or another when someone sees an investment advisor. Often, the person will get some combinations of the responses below:

1. You need to take a certain level of risk to achieve your target return.
2. You should increase/decrease your portfolio risk to fit your risk profile.
3. Higher risk means higher return.
4. You need to have a diversified portfolio to lower risk and volatility. 

Generally though there is no explanation of what risk means and how it relates to your investments. Most people think of risk as how likely am I to lose money and how much can I lose. However this is not the risk that investment products prospectus/financial advisors refers to. Risk when mentioned in this context usually refers to how volatile the investment’s price or daily return is. If the price of a stock does not fluctuate much on a day to day basis then that stock would be considered to be low risk, regardless of its actual return. Conversely a riskier stock is one whose price fluctuates widely on a day to day basis. This applies in general to any investments you can buy. The more widely an investment’s daily price or return fluctuates, the more volatile the investment is considered to be and the riskier the investment is considered to be.

Volatility can be measured in terms of daily price change or daily return, and how widely it fluctuates around the average price or daily return. For example if investment A has a 10 days daily return of: -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1% for a total 10 day return of -1%. Investment B has a 10 day daily return of 1%, 2%, 0%, 1%, 0%, 1.5%, 0%, 1%, 2%, 0% for a total return of 7.5%. However in this case investment A is considered to be a low risk investment because it’s daily return volatility is almost 0. Investment B even though has a higher return is considered to be higher risk because its daily return fluctuates much more than investment A. As well, investment A’s daily price is very close to its 10 day average price while investment B’s daily price fluctuates much more around its 10 day average price (look up standard deviation on wikipedia if you want more information). So risk when discussed in context of investing in stocks, bonds, mutual funds, etc, refers only to how widely the daily price or return the investment you are investing in fluctuates.

Note, in the example above, I’m merely trying to illustrate the point that low risk investments do not mean you will not lose money. However higher risk does NOT equal higher return! This is an extremely important point!

High price or return volatility means you are more likely to have large price movements, either positive or negative, making it harder to predict with reasonable accuracy what likely total return or value of the investment will be in the future. You can estimate a likely range of the investment’s total return or value in the future using statistical techniques but the range will be wide. For a no risk 5 GIC paying 3% interest per year, you can be fairly certain what your return will be each year and how much money you will have after 5 years. With a stock however, it is almost impossible to predict your yearly return or how much your investment will be worth after 5 years. 

So risk and return are linked but the important thing to recognize is one does not guarantee or imply the other. High risk does not mean you will get higher return for taking the risk. Taking high risk merely gives the chance to get higher return but at the price of a higher, potentially, much higher chance of losing a lot of your money! Remember, if you lose 50% of your principle, you will need a 100% return to just breakeven. So if a high risk investments gives 30% chance to make 25%, a 30% chance of 0% return, and a 40% of losing 15% each year, is it really a good investment to make? Is it guaranteed to do better than say a low return investment like GIC paying 3% a year after 10 years? The answer is no, there is no guarantee a high risk, potentially higher return investment will do better over the long term compared to a low risk low return investment. An easy example is the total return of 5 year GIC compared to the S&P 500 Index from 2000 to present. Someone employing a buy and hold strategy or even a dollar cost averaging strategy (purchasing a set amount regularly) buying 5 GIC would probably be ahead of another person invested in the general stock market.

Similarly, while combining a risk free investment with a high risk investment lowers the portfolio risk, it does not eliminate it. Having risk free investments do not mean you can invest rest of your money in high risk, potentially high return assets and achieve a high return or at worst breakeven. 

Risk taking does not in any way guarantee higher return. If high returns are guaranteed just from taking the risk then why is it even risk? Something is high risk because there is a good chance you will lose a lot or all of your money. If there is no risk of loss then it’s not risk!

Lastly, market risk is simply one type of risk in the investment worlds and there are many other risks that are equally or sometimes even more important. Thus, when making investing decisions, just looking at historical return and risk profile is not sufficient to make a decision.