Investment And Risk
What is investment "risk"?
There's really many different types of risk with investment. Usually, when people are talking about investment risk, they are thinking about specific risks to a specific investment. The risk of a stock is many times its volatility, how much the price of that stock goes up and down. The risk of a bond could be that the company defaults on that bond and doesn't make its payments back to you, or maybe the growth of a bond, the interest, doesn't keep up with inflation. When it comes to risk, it is important for people to realize that our goal in investing isn't to eliminate risks. If we do, we should have no expectation of really getting added returns. It's through taking risks that we as investors are going to earn added returns. That's really the process that investing is all about. It's eliminating the risks if we can and managing and understanding the risks that are going to give us an expectation of superior growth in our investment portfolio over time.
What is "risk tolerance"?
There are really two components of risk, there's the personal, psychological aspect of risk and then there's the more economic or mathematical aspect of risk. The psychological risk is really if we can as an individual handle the risk that we're intentionally taking on our portfolio to reach our goal. A classic example would be a market crash; a stock market downturn. Can we psychologically watch our investments lose money and stay with our investment strategy over that long term period? The more economic aspect of risk is really if the portfolio itself can continue to provide; maintain the goal that it's set up to maintain through whatever risk that it may have. So, back to the market downturn scenario, if you're retired and your portfolio was paying you money every month or every year, and the market starts to go into a negative place, can your portfolio continue to provide that income to you and yet be able to make it through the recovery and maintain your long-term cash flow through retirement?
What is the benefit of diversification?
Diversification in its traditional sense is the process of eliminating risks by owning multiple securities. A classic example is you can have the risk associated with an individual stock, but by owning many stocks - 2, 3, 4, 5 stocks - you can eliminate the risk of a single stock and that would do the same thing for certain sectors. By using diversification, by owning multiple sectors, you can eliminate the risk of an individual sector.
What is a "risk premium"?
A "risk premium" is the expected return for actually taking a risk above a risk-free rate of return.
What is a "diversifiable risk" versus a "non-diversifiable risk"?
There are two types of risk. There's the traditional form of risk, which is a diversifiable risk, where you can eliminate a risk by owning many securities. A non-diversifiable risk is actually the risks we want to take, since we can't eliminate those risks. Non-diversifiable risks are the risks that give us the returns that we're actually going in and investing. Those are the risks we want to seek out as investors: the non-diversifiable risks.
How do I determine my "risk profile"?
Determining one's risk profile is really a difficult thing to do. What we are saying with a risk profile is usually it's your individual risk profile. How much risk tolerance can you as an individual take. The problem with that is the place you are when you are thinking about what your risk profile is going to be, is different than actually being in that risky situation. If we are in a time when the market is doing really well, it is easy for you to stand back and say, "Oh yeah, I can accept a 1% loss." When you are actually in the middle of that 1% loss of your portfolio you are going to feel very different. Traditionally, risk profile is a way of finding out how much risk can you take. In practice, they really aren't that helpful because we are always asking the questions in a different environment than the actual risk we are concerned with.
How should my risk profile impact my investment decisions?
The risk profile is important for looking at investment decisions, because investing is really a long-term prospect. However, most of the risks that we assume when we invest are short-term in nature. And back to that classic market crash, that's a short-term process. So if you can't handle that short-term risk, you're never going to reach your long-term investment goal. The risk profile really tells us how much short-term possible loss we can let an investor take so that they'll stick with their long-term strategy, and as a result be successful in reaching their goal.
Is investing in the stock market riskier than other types of investments?
Investing in the stock market in the traditional sense of risk is probably riskier than investing in bonds, meaning that in a short period of time, you have a greater probability that your money will go down. If you need your money right away, you'll actually get less than what you started with. That could be a classic example of risk. However, if you're a long-term investor, over long periods of time stocks have tended to outperform bonds. Depending on what the actual risk is we're concerned with is really whether or not stocks are riskier than other investments.
What are the safest types of investments?
Traditionally, the safest types of investments are going to be fixed-income investments, or bond investments. Probably one of the safest is going to be a CD, or certificate of deposit. Not only is that a fixed-income investment, but your money is actually insured by the federal government. From there, US government bonds are also considered really, really safe. The US government is not going to default on its payment of its bonds, and so that's definitely a safe investment. And then from there, there would be corporate bonds, and depending on the quality and size of the company would start to tell you the credit quality of that company. So a very, very large, well-established firm probably has a very unlikely chance that it is going to default on its bonds relative, let's say, to a new, startup company that might have a lot more risk.
