Risk: a word that runs rampant in our society. We talk about risk in relation to physical activity, personal relationships, gambling, and – of course – investments. Finding the perfect balance of risky – but not too risky – investments is the ultimate dream, right? It’s a lot like, say, betting on a horse race. You can place a safe $50 bet on the favorite, and potentially get $60 back. Or you can place a risky $50 bet on the long shot, and potentially get $500 back.
So how do you strike a balance between the low risk, low reward scenario and the high risk, high reward scenario? We don’t have a short answer to that question. But we do have thoughts, expert opinions, and suggestions.
Risk vs. Volatility
Let’s start by talking about what exactly risk is. A definition of risk has long eluded investors and finance experts. Unfortunately, it is just not a straightforward, quantifiable idea. Thus, there is not necessarily a generally accepted and agreed-upon definition – or measurement – of risk in the world of financial planning.
Volatility, however, has a definition. It is defined as the statistical measure of the dispersion of returns for a given index. Using the standard deviation of returns from the same index, it is relatively easy to measure volatility. And it sounds a lot like risk; the more possibilities of return an index holds, the more likely some of those returns will be bad.
Now, this is getting us somewhere, but it’s still not exactly what risk is. Just because an index is volatile, doesn’t mean it is risky. There may be many options as to what your return could be, but the simple fact that lots of possibilities exist does not necessarily (an important word) have an effect on the likelihood of each possibility occurring.
We’ve talked a lot about what risk isn’t, now let’s talk about what it is. Instead of imposing an absolute definition of risk, we’ll offer a way to think about what it is: the possibility of an index underperforming, and/or of the investor experiencing a loss of capital. So, if you make an investment and expect a return of 20%, the likelihood that you will receive a return of less than 20% is the risk of that investment.
High Risk vs. Low Risk Investing
The topic of risk comes up very often when we talk with clients. People want to know “how risky” to make their investments. Of course, there is no catch-all answer to this. The truth is that everyone has a different level of comfort when it comes to investments and risk.
To help you think about where your level of “risk comfort” lies, let’s look at the differences between high risk and low risk investments.
High risk investments occur when the index in which you’re investing has a high chance of under-performing, or of losing capital. This can be somewhat subjective. Maybe you’d consider an investment with a 40% chance of earning your expected return very risky, while someone else would consider an investment very risky if it had a 10% or less chance of earning the expected return.
Something important to note about low risk investments is that not only do they protect against the chance of under-performing investments and loss of capital, but they also ensure that none of the potential losses will be devastating.
Hence when investing, remember that there are two sides to the risk coin: the possibility of a loss, and the severity of the loss. Your personal definition of a devastating or severe loss may be the parameters by which you should choose the level of risk your investments will be.
How We Can Help
Here at Saddock Wealth, we’ve been in the financial game for a while. We’ve witnessed, studied, and worked in many financial climates, and with a wide variety of clients. We’re very familiar with how to balance a client’s risk comfort level with investment opportunities.
However, every client is unique, and the absolute best way for us to determine a healthy level of investment for you is to talk to you. We pride ourselves in being extremely open and client-oriented. We’re happy to meet as often as you’d like, and over the years we’ve been able to earn our client’s trust. As far as risk goes, we always have suggestions on new and exciting investment opportunities, but we’ll never chase the latest fad or engage in mindless trend following when it comes to your wealth management and investments.