Risk, the misunderstood variable.
Everyone has heard of “risk”, but few take time to really understand it. What’s the difference between risk and uncertainty? What is volatility and can it be measured?
One risk "fact" is apparent; we face it in each action we take every day of our lives. We can easily evaluate the risk of parachuting out of an airplane because we have a mental concept of the probability of success or failure. We definitely know the result of failure. However, when it comes to investing, we have greater difficulty understanding the probabilities of success and failures and what a failure could mean. Unfortunately, this misunderstanding sometimes leads to completely avoiding the contemplation of risk and uncertainty all together.
Think about the last time you made an investment. Which of the following did you spend the most time contemplating:
- How much time did you spend looking at investment options?
- How much time did you spend looking at the current level of standard deviation in your portfolio?
- How much time did you spend evaluating the risk involved in each new investment option?
- How much time did you spend evaluating the past performance of the new investment options?
- How much time did you spend evaluating the correlation of the new investment options to that of existing?
Odds are, you spent more time evaluating the new investment options and their past performance. Join the crowd and follow the piper off the cliff.
Why does “risk” get less attention? It isn’t nearly as glamorous as “returns” and a lot harder to evaluate.
If you want to be successful, then you need to come to terms with risk. Getting intimate with risk can help you set realistic expectations, mitigate emotional reactions, and builds investing confidence. Your advisor can help you evaluate your risk capacity / tolerance. This is a building block to success and it’s highly unique to each individual. It’s even more important to know your capacity is DETERMINED BY YOU not the advisor. If you aren’t confident in this aspect of investing, then work with your advisor until you’ve got the confidence you need.
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