What is risk?
Risk is all around us, and we all take risks every day. Some people consider driving a car risky. Others don't seem to mind driving but don't like flying in an airplane--even though statistics show you're far more likely to die in a car than in an airplane. Some of us, like racecar drivers, cliff divers, and bungee jumpers, actually thrive on risk. Others go to great lengths to reduce risk.
Risk is multidimensional with many factors interacting. For example, an athlete in top physical condition may suffer a fatal heart attack while exercising because he or she has a family history of heart disease.
Some risks are more apparent than others. For instance, walking a high wire is quite obviously a risk. On the other hand, the danger of being struck by lightning is not so obvious.
The bottom line is that you can't live without taking some risks. Since you cannot totally eliminate them, the best you can do is try to manage them as much as possible. That's why we avoid people with colds, eat healthy diets, wear life jackets when we go boating, and buy life insurance.
Risk in the investment world
Some people view risk as a negative, others as an opportunity. Ask any group of people what risk means to them, and you are likely to get some of these answers:
- Possible loss
- Potential gain
In the investment world, risk generally is related to uncertainty. It refers to the possibility that you might lose your investment, or that an investment will yield less than its anticipated return. More simply stated, risk has traditionally referred to the probability that an investment will behave differently than expected. Every investment carries some degree of risk because its returns are unpredictable. The more volatile an investment is--the more unpredictable its returns--the riskier it is generally considered to be.
Within this framework, there are multiple ways of viewing risk. Modern Portfolio Theory (MPT), the basis of most portfolio planning processes since it was articulated in the 1950s, views risk as being two-sided; the greater an investment's deviation from an anticipated return--up or down--the riskier it is assumed to be. However, a concept sometimes referred to as Post-Modern Portfolio Theory (PMPT) also has begun to receive attention. It focuses primarily on downside risk: the possibility of loss, or of not meeting a specific investment target. This approach tends to estimate the statistical likelihood of a negative outcome--for example, the odds that a portfolio would fail to produce the return needed to produce a certain level of income for 30 years--and make plans based on that estimate.
The relationship between risk and return
When you invest, you plan to make money on that investment or, more accurately, earn a return. Risk and return are inversely related. In general, the higher the desired return, the greater the uncertainty about the end result; as a result, you are likely to have to take more risk to obtain it. Conversely, if you want a more certain outcome and lower risk, you may have to accept lower potential return. This is often referred to as the "risk-return tradeoff;" you generally must trade off a higher potential return in exchange for lower risk.
The relationship between risk and time, or the time horizon
The length of time that you plan to remain in a particular investment vehicle is known as your investment planning time horizon. Generally speaking, the longer your time horizon, the more aggressive you may be able to be by investing in higher-risk investments. This is because the longer you can remain invested, the more time you'll have to ride out fluctuations to try to achieve a higher return over that time. Of course, there is no assurance that any investment will not lose money.
Each individual is able to tolerate a different amount of investment risk. This is known as your risk-taking propensity or risk tolerance. Those who are comfortable taking more risk in exchange for the potential for a higher return are referred to as risk tolerant. On the other end of the scale, those who can accept very little risk are known as risk averse. Many people fall somewhere between these two ends of the risk tolerance spectrum.
There are ways to measure your risk tolerance, using tests to assess how you react to different types of risk, such as monetary, physical, social, and ethical. These tests aren't foolproof, since they generally measure psychological behaviors that may vary under different conditions, and may or may not take into account how your financial circumstances affect your risk tolerance. However, the results from these tests are generally considered reliable and valid.
In determining which investments match your risk-return expectations, your risk-taking propensity is as important as the risk of a given investment itself. If your risk tolerance proves to be lower than you initially thought, you may have difficulty sustaining a financial plan during difficult periods. Also, your risk tolerance may change over time as your circumstances change.
How do you evaluate the risk of a specific investment?
Before you can evaluate the risk of a specific investment, you must understand the types of risk that exist and how to measure them.
As in your day-to-day life, risks are prevalent in the investment world, and some are more apparent than others. Each investment is subject to all of the general uncertainties associated with that type of investment. These are known as systematic risks and include market, interest rate, and purchasing power risk, among others. Risk also arises from factors and circumstances that are specific to a particular company, industry, or class of investments. These are known as diversifiable or unsystematic risks, because they can be addressed (at least in part) by investing in more than just that one company, industry, or class. Diversifiable risks include business, financial, and default risk, among others.
Measuring risk involves analyzing the various types of risk using an array of mathematical tools and techniques (e.g., an investment's standard deviation, beta, alpha, and so forth). The statistics obtained provide an investor with some standardized measurements with which to make an educated decision.
Rating services, such as Standard & Poor's, Fitch, Moody's, Value Line, and Morningstar, compile and publish risk and return statistics for many types of investments. Though they are not infallible, these services provide an investor with key information and statistics in a condensed and easy-to-read format, and often give some context for assessing the data.
To obtain rating service reports, check with your public library. It may subscribe to some or all of these services. You also may find information online.
To do investment research, you may be able to view an annual report, prospectus, or proxy statement with financial information and outlined business strategies. To obtain copies of these documents, contact the issuer of the security. You also may find helpful information in books, newspapers, magazines, journals, newsletters, or online sources.
How do you reduce risk?
One of the most common ways to reduce risk is to develop a portfolio of investments that is balanced in terms of the types of assets in which you invest. In other words, in designing and managing an investment portfolio, don't put all your eggs in one basket. This is known as diversification. According to Modern Portfolio Theory, a portfolio that mixes a variety of asset classes (e.g., cash, bonds, domestic and foreign stocks, and real estate) generally has a lower risk for a given level of return than a portfolio that consists of only one of those classes, or a portfolio whose assets are highly correlated and tend to behave in similar ways. Diversification works because it broadens your investment base (though it can't guarantee a profit or protect against a possible loss). It can be achieved by company, industry, type of security, markets, or by investment objective.
How an investor diversifies depends upon his or her own situation. An investor can be aggressive (investing mostly in high-risk vehicles), conservative (investing mostly in low-risk vehicles), or somewhere in between (often by using some combination of high- and low-risk investments).
Allow for the passage of time
Historically, time has helped moderate the riskiness of some investments (though there is no guarantee this will continue in the future). In "investmentspeak," the standard deviation associated with the average rate of return on an investment--the extent to which returns vary from historical norms-tends to decrease over time. In plain English, the longer the investor remained invested--or the longer the investor's time horizon--the more the return over that time will tend to resemble the historical average.
Do your homework
You may be able to reduce some risk simply by being diligent. For example, have real estate inspected and appraised before you buy it, or investigate a company's financial condition before you purchase stock in it.
Gauge the economy by identifying trends in overall business conditions. These trends are indicated regularly (weekly or monthly) by figures on inventories, prices, employment, and the GDP. Is the economy on an upswing or downswing? Knowing this will help you choose an investment you believe is likely to appreciate under the given conditions.
Make sure you understand why you're buying an investment and what role you want it to play in your portfolio. In addition to making you a more informed investor, this also can help you gauge when to sell it.