Risk. As a word it’s inherently negative, especially when it comes to health or disability insurance. When it comes to investing, risk is neither good nor bad. It can yield both positive and negative returns.
Recognizing risk and assessing it, is part of a plan and process rather than something to be avoided.
Market Risk vs. Business Risk
There are many different kinds of risk, but when it comes to recognizing risk in finance, investors look at business risks and market risks.
According to the Financial Industry Regulatory Authority (FINRA), business risks are “associated with investing in a particular product, company, or industry sector.” These include management risk, which refers to management team decision making. If management puts their own interests above those of the company, or does something fraudulent, or gets involved in some kind of scandal, their actions count as risk for the company in question.
Market risk, on the other hand, “involves factors that affect the overall economy or securities markets. It is the risk that an overall market will decline, bringing down the value of an individual investment in a company regardless of that company’s growth, revenues, earnings, management, and capital structure,” (FINRA).
Some common market risks include: interest rate risk, inflation risk, currency risk, liquidity risk, sociopolitical risk, country risk, and legal remedies risk.
Whoa. That’s a lot of risk. None of which are inherently bad. Learning to recognize risk, and to be aware of how various risks can affect a portfolio, is important.
Okay, we recognize the risk. We can identify that it is, or could be, affecting our investment portfolio. But, truth be told, knowing risk is there doesn’t solve any problems. Recognizing it is the first step. Measuring it and understanding how it can affect your investment(s) is the next.
There are many different ways to measure and quantify risk so that we understand how it will affect an investment. Standard deviation, chance of loss, beta ratios…however, this is where recognizing risk is good in theory, but difficult in practice. For example:
Beta is a measure of a stock’s volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market.
A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0.
High-beta stocks are supposed to be riskier, but provide a potential for higher returns; low-beta stocks pose less risk, but also lower returns.
Simple, right? Maybe for some, but overall, risk assessment is a question to ask your financial advisor. That said, it is our ability to recognize risk, and understand how it can affect our portfolio, that is pivotal to asking a professional the right questions.
Recognizing Risk Aversion
Asking the right questions is important, but so is knowing some answers. When we first sit down with an advisor, planner or broker, the question of risk comes up.
What are you comfortable with? What factors should we be considering? Age? Liquidity? Are you risk-averse? Many of us don’t know the answers to these questions. If we do, they may have changed over time.
Recognizing risk isn’t just about knowing that some risk is essential in an investment mix. It is important to realize when and where we shouldn’t carry risk.
“Bonds are supposed to be boring. The primary role they serve in our portfolios is not necessarily to make money, but to dampen the volatility that is an inevitable byproduct of the real moneymakers—stocks,” (“Don’t Let Wall Street Fool You Into Taking Too Much Risk”, Forbes).
Recognizing Risk Tolerance
Just like the word risk, the words “safe” and “conservative” can have different meanings for different people. In an effort to identify “safe” investments, some people can’t avoid risk.
What’s riskier? Investing in something safe, with returns that could get eaten away by inflation? Or tolerating risks for bigger returns?
“Facing a potentially longer lifespan than their parents, many investors in their 50s and early 60s need to be more open minded and take on more risk to avoid outliving their nest eggs, financial advisors say,” (“Pre-retirees seeking safe investments can’t avoid risk”, The Globe and Mail).
“Millennials and, to some extent, GenXers, are risk averse and conservative in their investing approach. Given their long-term investment horizon, this perspective could be harmful to their retirement planning,” (Report: Loss Aversion and Your Investment Portfolio, Sun Life Global Investments).
Risk: The Financial Equivalent of Eating Your Broccoli
Recognizing risk and assessing our tolerance for it will help us ask the right questions when we talk to our financial advisors, but it also helps define and achieve the big picture of saving for retirement.
The Sun Life Global Investments report explains it well:
“If you understand how taking prudent risks can help you meet your long-term objectives, you may be willing to accept risks you would otherwise reject—not because your natural loss aversion is gone, but because you know that dealing with the discomfort caused by volatility is in your best interest. It’s the financial equivalent of eating your broccoli—you do it because it’s good for you, not because you like it.”