Risk is a fundamental element in investing. When discussing performance or returns, it is essential to mention the risk involved in the process. New investors struggle to figure out the differences between low risk and high risk.
Many new investors think that fundamental risk is a quantifiable and well-defined idea to investments. Unfortunately, they are wrong, and it is not as they believe. However, there is still no actual agreement on the idea of risk and how it should be measured.
Academics have often attempted to use volatility as a representative for risk. To a certain degree, this idea can make sense. Volatility can measure how much a number can change over time. If the range of possibilities is wide, some of those possibilities will definitely be bad. The good news is that volatility is moderately easy to measure.
Unfortunately, volatility is inaccurate as a measure of risk. However, a more volatile stock or bond does not necessarily affect the likelihood of those outcomes, but they indeed expose the owner to a broader range of possible outcomes. In other words, volatility resembles the turbulence passenger experiences on an airplane. It feels unpleasant, but it does not have much of a connection to the possibility of a crash.
A better way of understanding risk is the probability or possibility of an asset experiencing a below-expectation performance or permanent loss of value. If an investor purchases an asset with the expectation that it will return 10%, the possibility that the return will be below the expectation is the risk of this investment. It also means that underperformance related to an index is not always a risk.
Risk has no perfect measurements and definitions.
New investors would do fine to think of the risk that a given investment will fail to reach the expected return and miss the target.
To better understand what risk is, investors can build portfolios with a lower probability of loss and a lower maximum potential loss.
A high-risk investment represents a relatively high chance of a devastating loss or a significant percentage chance of capital loss or under-performance. One of these possibilities is intuitive: If you receive information that there’s a 50/50 chance that you earn your expected return from your investment, you might find that quite risky. If you were told that there is a 95% chance of not earning your expected return, most investors would agree that it is risky.
Another way of describing it is the one that most investors forget to consider. To illustrate it, we can take car and airplane crashes as examples. According to a 2019 National Safety Council analysis, a person’s lifetime chances of dying from any accidental cause have increased to one in 25 from chances of one in 30 ten years ago. However, the chances of dying in a car crash are only one in 108, while the chances of dying by lightning are one in 138,848. This means that investors have to consider both the probability and the size of bad outcomes.
By nature, there is less at stake with low-risk investing. It is so in terms of the amount invested or its significance to the portfolio. There is also less to gain in terms of the potential benefit or the potential return.
Low-risk investing means protecting against the chance of any loss while making sure that none of the possible losses will be overwhelming and devastating.
Suppose investors accept the idea that a loss of capital or underperformance relative to expectations defines investment risk. In that case, it makes determining low-risk and high-risk investments considerably easier.
We can further consider a few examples to illustrate the difference between these two types of risky investments.
Biotechnology stocks are considered particularly risky. The large majority of new experimental medicines will fail, and most biotech stocks will also ultimately fail. Therefore, there is a high chance of underperformance.
In comparison, a United States Treasury bond can offer a rather diverse risk profile. There is practically zero chance that an investor having a Treasury bond will fail to receive the principal payments and stated interest. Even if there were payment delays, investors would recover a large portion of the investment.
It is also essential for new traders to consider the impact that diversification might have on the risk of a portfolio. The dividend-paying stocks in general and especially of major Fortune 100 corporations are pretty safe. Investors might earn with them mid-to-high returns for many years.
Experts say that there is always a risk that an individual company will someday fail. Companies such as Woolworths and Kodak are great examples of one-time success stories that finally went south. Besides, market volatility is always probable.
Suppose investors decide to hold all of their money in one stock. In that case, the probability of a lousy performance might still be moderately low, but the potential sharpness is relatively high.
All investors have to be willing to look at risk in general and adaptable ways. For example, diversification is an essential part of the risk. Holding a portfolio of investments with low risk can be pretty dangerous. For instance, while the chances of an individual plane crash are scarce, many big airlines still can experience a crash. Holding a portfolio of low-risk Treasury bonds might seem to come with a very low-risk investment. But in the end, they all share the same risks. The appearance of a very low-probability event, such as a default of the U.S. government, would be disastrous.
Investors also have to include and consider several factors–for example, time horizon and knowledge when assessing risk. Overall, if the investor waits for longer, that investor is more likely to obtain the expected returns. There is undoubtedly some correspondence between risk and return. Therefore, investors wishing for huge returns have to accept a much more significant risk of underperformance. Knowledge is also essential in identifying risks and managing investments. Such investors are likely to achieve their expected return.
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