Broker Check
Five Important Aspects of Investment Risk

Five Important Aspects of Investment Risk

February 13, 2024

One of the foundational elements of financial and investment planning is the management of risk. In a perfect world, we would not have any risks, and life would be a beautiful thing. However, it always surrounds us. Whether you are driving to work or sleeping in your bed, there is some element of risk. You may be taking on more risks when you get in your car than when you are sleeping but a myriad of things can happen to you in bed, as well (let your imagination run wild).

There are several types of risk but, for the purposes of this article, we will refer to risk as the historical volatility of an investment, measured as standard deviation. The higher the standard deviation, the higher the volatility/risk. In investment management, we often seek to  reduce this volatility while pursuing the highest return possible, relative to the risk tolerance. In this post, my goal is to help you understand how risk is related to return and why you need to figure out your risk tolerance when building a portfolio. Here are five important things I'd like to share with you about risk management:

  • Higher investment returns often come from higher risk investments. While working with wealth management clients, I find the risk-return tradeoff to be a difficult concept for many to understand. I often hear, “I want to get the most return possible.” When I ask about how much risk they are willing to take, the response is sometimes, “I don’t want to take on much risk.”

This relationship between risk and return can cause an investor to make costly mistakes in their investment strategy. If a client invests too riskily, they may not get the returns they desired or they may even have losses. It is important to mention here that historical performance of an investment is no guarantee of future performance.

Why do higher returns often come from higher volatility investments? When we purchase an asset as an investment, our goal is to get a positive return. If there is a chance we might lose, we want to get some type of reward for our investment and for taking that risk. As the risk of loss increases, we want more compensation for that risk. If there is negligible risk, we do not need as much compensation or return.

  • Higher risk investments do not always deliver higher returns. While it may be true that higher returns often come from higher risk investments, not all higher risk investments provide higher returns. If an investment is highly volatile, as measured by standard deviation, it may provide higher returns. It is also possible that the investment will lead to a loss or simply will not perform well. Risk means you are taking a risk… period. You should consider potential losses when choosing any investment. If you are choosing between two investments, risk is just one piece of the portfolio puzzle. There are a lot of other factors to consider.
  • There are eight risks that can affect the volatility of an investment. These include market risk (fluctuation of price), liquidity risk (difficulty in selling), concentration risk (lack of diversification), credit risk (company defaults or goes bankrupt), reinvestment risk (inability to find like or better returns when investment matures), longevity risk (outliving your money), inflation risk (loss of purchasing power), and horizon risk (lower time frame). When we strive to diversify away risks, we are trying to select investments that are uncorrelated across as many of these factors as possible.
  • Correlation of assets helps determine how well a portfolio is diversified. One way we diversify assets is to choose investments that offer similar long-term returns but move opposite each other. For example, highly correlated assets move in tandem at any given time in the market. When one asset grows, the other asset grows by the same amount. Uncorrelated assets have no similarity in how they move. Inversely correlated assets move opposite each other. When one is moving up, the other is moving down at the same rate. If we can find two assets that present similar returns over time but are inversely correlated, we may be able to reduce risk.
  • You cannot diversify away systematic risk. When the entire market is falling due to a major market event (systematic risk), that means most asset classes are falling, as well. However, some assets may fall at different rates. A notable example of this is the relationship between stocks and bonds. Stocks are typically more volatile than bonds and have a higher risk. When the market drops, investors may move to lower-risk assets like bonds. That can create a higher demand for bonds and a higher price. This might cause bonds to rise in value while stocks are falling. But this is not always the case. Other market events may cause stocks and bonds to fall at the same time. This can happen when interest rates are rising, and stocks are falling.

While the above five aspects of investment risk are important, they only scratch the surface of this subject. However, they help give you a basic understanding so you can think about your risk tolerance. As I mentioned in the first part of this article, you should consider your risk tolerance when building a portfolio or making an investment. There are numerous worksheets available to help you figure out your risk tolerance, and there are many ways to break down risk tolerance. Typically, risk tolerance ranges from “I want no risk” to “I am fine with high levels of volatility.” It is often broken down into five categories: conservative, moderate conservative, moderate, moderate aggressive, and aggressive. These range from low risk to high risk, respectively.

To make things more complicated, a wealth manager may divide your assets into different portfolios with different risk tolerances, based on your goals. For example, if you are saving and investing for your newborn baby’s college education, you may take on more risk, at first. With eighteen years to invest, you have plenty of time to recover from high market volatility. As you get closer to the goal, you may want to dial down the risk you are taking. If you have enough assets to build several portfolios for a goal that stretches out over many years, like retirement, it may be beneficial to build a conservative portfolio for your retirement withdrawals, but also have a portfolio that is more aggressive for ten plus years from now. That way, you can potentially increase your returns by taking on more risk in a portfolio that has time to recover.

With so many things to consider when examining investment risks, it makes sense that people are often confused with this discussion. Hopefully, by describing the above important topics related to risk, as well as the subject of risk tolerance, you now have a better understanding of how it affects your investments, goal setting, and financial planning. If you are not working with a wealth manager, I hope this helps you better understand why this is an important consideration when managing your investments. If you would like to know more, reach out to me any time.

The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.