Risky business: understanding and defining investment risk
By Scott Kyle
There’s an old wives tale about a student who gets an exam with the question, “What is Risk?” In response, he scribbles, “This Is,” turns in the test, and exits the room. No one knows if he gets an A or an F – but the story is a good one.
In the realm of investing, the concept of risk is discussed on a daily basis. However, the traditional method of defining investment risk – namely, by correlating risk to market volatility — is a terrible one at best. Pundits consistently associate market gyrations with high risk; but in the interests of smarter, more successful investing, let’s look at some alternative definitions of the word.
First, risk comes from not knowing what you are doing. To me, this is the best definition of risk (and one the great Warren Buffett uses as well). A knife in the hands of a baby poses great risk; the same blade in the palm of a surgeon saves lives. When it comes to investing, people take risks through simple ignorance. Ask the average investor a basic question about the companies in his portfolio and you will likely get a blank stare in return. Ask what the current stock price is, on the other hand, and you will receive a quote as fresh as a Krispy Kreme doughnut hot from the oven. But reciting a trading price and understanding its implications are two entirely different things; and it is within this knowledge gap that investors often take on unrealized risk.
Secondly, risk comes from mismatching time horizons. Competing in a marathon? Pace yourself. Is your house on fire? Forget the warm up and get your sprint on! In the world of finance, time frame largely dictates how funds should be allocated to avoid risk. If you need to make a down payment on a house in 6 months, then you should be sitting on cash: putting your assets in stocks risks capital deprecation when you need to liquidate. Alternatively, if the funds are for retirement, then cash is the riskiest place to put your money. Why? Because over time, stocks earn returns well above inflation, whereas cash loses money every year after inflation and taxes.
Finally, risk comes from not knowing the people managing your money. Most folks get to know their attorneys, CPAs and primary care physicians; but all too often, they hand their money over to a financial firm based on a TV commercial – generally without ever having met the person making investment decisions on their behalf.
There’s no doubt about it: stock markets can be volatile. But truthfully, short-term vacillations are just background noise in the long investment journey. For those interested in reducing risk, find a trusted professional who will serve as the primary decision maker — someone who will sit down with you and discuss your particular goals and objectives. Learn more about personalized San Diego money management services today: visit www.coastwisegroup.com.
The information in this article is strictly for educational and illustrative purposes and is not an attempt to furnish personalized investment advice or services.
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