Investors talk a lot about investment risk, but nobody seems to be able to define exactly what it is.
While we don’t need to precisely calculate risk, understanding it is essential to sound investment decision making. So, how should we think about it?
Risk means more things can happen than will happen
Perhaps Elroy Dimson, (Professor of Finance and Director of Research at Cambridge Judge Business School, Economist, Actuary and award-winning author) put it best, and most succinctly, when he said: “Risk means more things can happen than will happen.”
This definition gets to the core of how investors should consider risk. Risk is an absence of certainty. Risky situations are defined by there being a range of potential future outcomes and some unknowable probability attached to those outcomes.
Imagine if I make a parachute from items I found around my house and then proceed to jump from the top of the tallest building in the world – this is an extremely high risk decision with the range of outcomes as wide as you could get (I live – unlikely, I die – probably).
Alternatively, if I decide to simply jump from the top of that same tall building (absent homemade parachute) that wouldn’t be a risky decision because the result is certain (or close enough to it). Choices are not risky because they are bad, but because the consequence of them is uncertain.**
When investors assess risk they should always be thinking about the range of potential outcomes stemming from a decision and their likelihood.
Risk in Action
To bring this idea to life a little, let’s consider two types of financial market environment and what happens to our perception of risk during them.
In times of extreme market stress, such as that witnessed in many markets this year, many people start to believe that risk is increasing and try to behave in a risk-averse manner. Why is this? Two things are happening. Firstly, our sense of the range of potential outcomes is widening. Secondly, we start ascribing higher probabilities to bad outcomes.
Something close to a reverse of this situation occurs during bubbles. In spells of market exuberance peoples’ sense of the range of future outcomes narrows around high and unrealistic return outcomes, and many think the probability of such positive outcomes is increasing.
Bubbles are about performance chasing, social proof and storytelling, but they are also about a growing complacency around the real risk of an investment. In a bubble risk is growing but we act as if it is dissipating.
Time on our side? [THIS IS THE IMPORTANT STUFF SO FOCUS]
Investor time horizons have a huge impact on risk. When individuals extol the virtues of long-term investing and suggest it is less risky than adopting a short-term approach, what do they mean?
If we are investing in equities (shares) for one year – what does the risk look like? The range of plausible outcomes is incredibly wide (+40% and -40% is not unreasonable for diversified index exposure); furthermore, the probability of negative returns of this short period is not immaterial. While, even over just one year, equity returns are more likely to be positive than negative, that outcome is far from guaranteed.
If, however, we adopt a longer term philosophy – let’s say 30 years – the range of potential outcomes narrows and the probability of positive outcomes is materially improved. In simple terms, we would be far more confident that equities will generate positive performance over thirty years than a single year. There are good reasons for this. Over one year equity returns are driven largely by changes in sentiment; over 30 years it is the compound impact of earnings / reinvested earnings that will dominate.
This is why one of the crucial questions we ask you when discussing investments is your minimum investment horizon.
Diversification and Risk
Although diversification is by no means a free lunch, it is an effective means of reducing and controlling risk, if done prudently. It works because by combining securities and assets with different future potential return paths it significantly constrains the range of outcomes of the combined portfolio.
If we move from a single stock holding to a diversified 50 stock portfolio, we greatly lower the potential to make 10x our money, but also (nearly) entirely remove the risk of losing everything. Diversification is a tool whereby we can (very imperfectly) create a portfolio with a range of potential outcomes that we are comfortable with. When individuals complain about over-diversification, what they typically mean is that the range of outcomes has been narrowed so that average outcomes are very likely. There is, however, no right or wrong level, it simply depends on our tolerance for risk. Or, to put it another way, our appetite for extremely good or extremely bad results.
The Stakes are High
When talking about risk as there being a range of future outcomes with some probabilities attached to them, we have missed out an important element – what are we putting at risk? What is at stake? A decision may be very high risk, but of little consequence.
If I bet one year’s salary on a horse race, that is a very different type of risk than placing a R10 bet. The risk inherent in the activity remains the same (the horse I have gambled on still has the same range of outcomes no matter how much I bet), but the risks to me are not comparable.
Risk is about understanding the range of outcomes and their potential probabilities, and then judging what the appropriate stake is given our view on this.
When risk management goes wrong
Risk management often goes wrong, and it does so both behaviourally and technically. Behaviourally, because we have a plethora of biases – extrapolation, overconfidence, availability, recency etc – which mean we worry about the wrong things and are complacent about issues that should matter. Technically, because we try to precisely measure things where it is impossible to do so – inevitably becoming overly reliant on inherently limited metrics. If we use a single number to measure risk, we are not thinking about risk in the right way.
What is Good Risk Management?
We have tried to present what we think is the most realistic and sensible way for investors to think about risk, but what does that mean for good risk management?
We think there are three things that really matter:
- Understanding the potential range of outcomes and their probabilities.
- Reducing the probability of very bad outcomes.
- Increasing the probability of good outcomes.
Of course, all of these things are difficult to do and are inevitably based on the past – but then that is the point. If the range of outcomes is incredibly wide, then we need to know that – it will impact the choices we make.
We don’t know much about the future, but we know more things can happen than will happen. We invest with this in mind when recommending appropriate investment portfolios that are suitable for your individual and changing needs.
* This is an edited version of an article that first appeared here.
** Risk and uncertainty are technically different things, but for most of us that distinction is not particularly useful.